Sustainability-linked bonds: the sustainable financial product transforming debt capital raising

July 2022 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

July 2022 Issue

What if a company’s financing costs could be tied to its progress in reaching certain environmental, social and governance (ESG) targets, thereby incentivising not just prudent financial policies but also stewardship in a broader sense?

In September 2019, an Italian utility answered this question through the launch of the world’s first sustainability-linked bond, which set a target to increase renewable energy generation capacity; failure to achieve the target as of 31 December 2021 would have resulted in a step-up to the interest rate of 25 basis points being applied from the first interest period subsequent to the publication of the assurance report of the auditor reporting on the target.

This product, dubbed the ‘sustainability-linked’ bond (SLB), became formalised through the publication of voluntary international guidelines: the Sustainability-Linked Bond Principles (SLBP) in June 2020 by the International Capital Markets Association (ICMA). The SLBP require issuers to: (i) select their key performance indicators (KPIs); (ii) determine the related sustainability performance targets (SPTs); and (iii) when they are tested, determine the financial impact on the bond upon achievement or non-achievement of the SPTs. Issuers are then required to establish reporting and verification procedures, typically through a pre-issuance second-party opinion report passing on the alignment of the SLB with the SLBP and post-issuance external verification providing limited assurance on the KPI calculation and the measurement of the SPT.

In contrast to a green bond, there are no restrictions on the use of proceeds from an SLB – the issuer may use the proceeds for any purpose, not just for investing in ‘green’ projects or related expenditure. Instead, the financial terms of an SLB (usually the interest rate) will be subject to adjustment depending on the performance of the relevant KPIs as measured against the SPTs. As a result of this flexibility and adaptability, which rendered it suitable for a wide range of industries and capital-raising needs, the SLB rapidly became widely adopted.

While new green, social and sustainable (GSS) bond volumes increased by approximately 46 percent from $730.5bn in 2020 to $1.1 trillion in 2021, SLB volumes grew by approximately 10 times in 2021 (to $135bn) compared to 2020 – SLBs were the fastest growing ESG financial product category in 2021. Issuers from carbon-intensive industries for whom it may be otherwise impractical to issue green bonds can nonetheless tap the SLB market.

In the early stages of the SLB market, each announced deal was celebrated, typically oversubscribed and the issuer was recognised as being on the vanguard of ESG. Breakthrough deals have highlighted the ability to align ESG concerns with the financing policy of issuers in such sectors as cement, fashion, fast-moving consumer goods retail, pharmaceutical and energy, shining a light on the efforts of certain issuers in these areas to improve their sustainability footprint, and conversely, spurring peers to take their own action.

At the current crossroads of SLBs

Today, the market continues to mature. Issuance volume, albeit momentarily down due to geopolitical and macroeconomic concerns, exhibits strong structural drivers. Additionally, issuance of SLBs is becoming more prevalent in the US market generally and the product is rapidly becoming the ESG financial product of choice for the sub-investment grade market.

These factors combine with greater awareness of the SLB product on the part of analysts, rating agencies, regulators, investors and treasurers. We can discern a number of current topics of interest that boards of directors and management teams should carefully consider, as outlined below.

Focus has increasingly shifted toward understanding the calculation and methodology of the KPIs, including if they are performed with reference to international or industry benchmarks (such as the Greenhouse Gas Protocol). It is becoming important that environmental KPIs cover the core activity of the issuer and for management to disclose the transition strategy providing them with levers to affect change.

For SPTs, it is becoming more relevant for issuers to set core, ambitious and material goals that are scientifically sound (i.e., are aligned with a 1.5 or 2 degree Celsius global warming scenario or with net zero). The robustness of KPIs and SPTs is critical to address ‘greenwashing’ concerns. Greater transparency in KPIs also permits investors to benchmark across issuers and construct ‘ESG leader’ portfolios.

The centre of gravity of the SLB market remains in Europe. However, this is changing, and it is specifically accepted that there may be regional variations in KPIs and SPTs. This is particularly relevant for issuers in the developing world. Additionally, market practice is crystallising around the identification of certain KPIs that are most relevant to track for sectors such as construction, energy and pharmaceuticals.

Discussion is currently centred around how to better integrate sustainability terms into the bond, particularly with respect to the features listed below.

First, as SLBs penetrate the sub-investment grade space where call options at par a number of years after issuance are common, the market is beginning to evaluate whether assumptions should be made as to the SPT trigger event that will be activated when calculating the redemption price. Integrating the interest step-up or premium payment into ‘make whole calls’ for investment grade SLBs continues to be a lively debate.

Second, while interest step-ups in the SLB market remain relatively de minimis (not usually exceeding 25 basis points), ICMA guidance that such step-ups be ‘meaningful’ and should signal the issuer’s level of commitment given its size and market conditions leads to calls for a more material step-up.

Early SLBs did not include provisions providing for the recalculation of KPIs or SPTs upon the occurrence of mergers, acquisitions, disposals or changes to the calculation methodology. Today’s deals are tackling these questions, through the inclusion of recalculation policies (or similar), permitting (or requiring) KPI baselines and KPI performance to be recalculated due to a change in perimeter, suspending a step-up in the event of a force majeure, and allowing the issuer to adopt updates to calculation methodologies.

Typically these changes can be made without consent of the holders. However, recent proposals include certain protections such as an updated second-party opinion and lack of adverse impact on the holders. Guidance under the SLBP included a suggestion that frequent SLB issuers incorporate a most favoured nation clause to provide for the alignment of SPTs to subsequent issuances if they are more ambitious. This has not been widely adopted but remains a topic of discussion for frequent issuers.

At this juncture, ESG concerns have come to the forefront of investment decisions, and investors now look to SLBs as a capstone of a broader ESG pivot. Issuers are advised to disclose their wider transition strategy, and provide additional information regarding their operations, governance and risk management practices related to climate and sustainability topics generally. The voluntary guidelines contained in the ‘ICMA Climate Transition Finance Handbook’ can provide inspiration even if transition bonds (a distinct sustainable finance product) have not become common.

SLBs 2.0 and beyond

We predict a number of trends will dominate the debate in the next few years based on the direction of travel. In September 2020, the European Central Bank announced it would purchase SLBs that were otherwise eligible for its Eurosystem Corporate Sector Purchase Programme (CSPP). The CSPP stimulated supply for SLBs in the eurozone among investment grade issuers, which still comprise the bulk of the issuance volume.

The CSSP is expected to be discontinued in June 2022. Critically, the CSPP limited itself to purchasing SLBs with environmental SPTs. This may explain why the majority of KPIs tend to be environmental focused. With the end of the CSPP, it is possible that the pool of issuers familiar with SLBs as well as the demand from ESG-aligned investors spurs greater focus on ‘S’ and ‘G’ KPIs.

SLBs have penetrated additional finance products and we expect they will continue to do so. We have seen sustainability-linked convertible and exchangeable bonds, and the first green shoots of asset-backed products. Hybrids and bank capital products may be next if rating agency methodologies evolve.

Outside of public deals, we believe that private capital transactions offer enormous potential as these deals may lead to greater testing and innovation of bond characteristics that will cross-pollinate into public deals in due course.

Scrutiny by regulators, non-governmental groups and other stakeholders will likely increase as the SLB market evolves and deepens. In the future, we expect greater standardisation of definitions and methodologies and the use of sectoral SPTs endorsed by investor groups or trade associations.

Additionally, as various disclosure regimes come online and require robust information regarding greenhouse gas emissions and other environmental matters such the Task Force on Climate-related Financial Disclosures, the European Union (EU) Sustainable Finance Disclosure Regulation and the proposed Securities and Exchange Commission (SEC) rules on climate-related disclosure, additional data will become available that can facilitate comparability and benchmarking across issuers.

Looking even further ahead, it is possible that investors will seek more structural enhancements to SLBs, including more frequent and potentially more material step-up adjustments. There could also be greater penetration of the economic terms of the bond and alignment with KPIs and SPTs and net-zero commitments – for example, testing of carbon intensity in order to access certain dividend or debt incurrence baskets, thereby rewarding issuers that demonstrate ESG leadership, though it may take some time before such a leap is required and it may only be in private deals.

We believe that that SLBs are pointing the way to the future of debt capital raising where the rate of interest and the rate of change toward the energy transition are in alignment. The SLB market is burgeoning, and many innovations are yet to be seen, but the structural trend is already clear.

Roberto Reyes Gaskin, Edward Kempson and Jason Ewart are partners at Latham & Watkins LLP. Mr Gaskin can be contacted on +33 (1) 4062 2129 or by email: roberto.reyesgaskin@lw.com. Mr Kempson can be contacted on +44 (0)20 710 5808 or by email: edward.kempson@lw.com. Mr Ewart can be contacted on +1 (212) 906 4692 or by email: jason.ewart@lw.com.

Roberto Reyes Gaskin, Edward Kempson and Jason Ewart

Latham & Watkins LLP