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ESG Focus: Linked Finance The Next Big Thing, Part 1

ESG Focus | Sep 07 2021

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: Linked finance the next big thing – Part 1

Sustainability-linked finance has kicked off with a bang and is preparing to take the world by storm: it is tipped to hit US$17trn within five years and it’s a whole new ball game.

-Aiming for a broader church
-The carrot and the stick
-All aboard for transitioners – all off for greenwashers
-A solution for emerging markets?

By Sarah Mills

Sustainability-linked finance (SLF) was launched in late 2019 and is set to take the world by storm.

To date, the ESG finance market, which should surpass US$1trn in 2021, has represented a fraction of the US$120trn global debt ocean.

Sustainability-linked issuance represents just a fraction of that again, but not for long.

Observers expect it will take off in the second half of 2021 and will barely have time to catch its breath this decade.

To date, the bulk of ESG issuance has comprised use-of-proceeds loans such as green and social bonds earmarked for specific projects.

But use-of-proceeds bonds play to a select few, such as the energy and materials industries, excluding the vast majority of issuers.

SLF seeks to establish a broader church, drawing the majority of the world’s corporations, organisations and individuals into the UN’s sustainability drive, supporting projects as diverse as water management to mental health.

A broader church means more money and greater diversity of funds, and SLF is forecast to grow at an exponential compound annual growth rate of 98.32% to more than US$17trn within five years, according to Knowledge Sourcing Intelligence.

Others are aiming higher, noting investments in infrastructure are expected to reach US$90trn by 2030.

Already demand for environmental and social issuance far outstrips supply, with even marginally beneficial issuance 3-5 times oversubscribed.

SLF was developed not just to address the broader spectrum of environmental challenges, but as transition financing solution; a greenwashing solution; and a more flexible tool for investing in emerging markets. 

Sustainability-linked bonds can also increase portfolio diversification given use-of-proceeds bonds exclude the participation of the broader market.

There are two main SLF categories: sustainability-linked bonds (SLBs) and sustainability-linked loans (SLLs).

This article focuses on general issues affecting the broader SLF market. A second article will examine SLF penalty mechanisms, a third article the SLB markets, and the fourth will cover SLLs.

Key features of SLF

Sustainability-linked financing is best understood as an incentivisation structure: a “pay for success”, “penalise for failure” vehicle that funds social and environmental projects.

SLF can be applied to a range of sustainable purposes, from transitioning, to water management, diversity, circularity, health, housing, and infrastructure. 

SLF differs from most use-of-proceeds bonds in that the proceeds are not earmarked for specific projects but for general sustainability purposes, offering a broader destination for funds.

But the main difference is that SLF interest rates are tied to environmental and social outcomes via key performance indicators (KPIs) and sustainability performance indicators (SPIs) against a set of sustainability performance targets (SPTs),  which in turn are generally linked to the UN’s Sustainable Development Goals (SDGs) – a list of acronyms that would make a colonel proud.

The market is dominated by financials, utilities and REITS, which account for one third of total SLB issuance.

The carrot and the stick

Should a borrower fail to meet the KPIs and SPIs set in the borrowing contract, it may have to pay a step-up in the coupon, or a pre-agreed penalty.

Should an issuer’s metrics outperform those set in the contract, there is talk of step-down coupons as a reward and an incentive, but this is a hotly contested idea and exists more in theory than reality.

Critics believe step-up coupons (the stick) should provide sufficient incentive to borrowers to meet targets; and that attracting the attention of capital through outperformance should be the carrot, nullifying the need for a step-down.

Investors to feast at the SLF smorgasbord

SLF can be used for a range of projects. 

Initially, the transition agenda will drive the market’s growth. 

For the transition to succeed, not only must energy companies transition, the whole of society must transition to a low-carbon format.

Motor vehicles and service stations are the more obvious examples. But as the impact investment market kicks in, introducing technologies that slash carbon usage and reduce energy consumption, every part of society is expected to purchase these products.

Think insulation, water conservation devices and green mortgages for the residential market.

Companies may find themselves investing in insulation; low-energy lighting; low-carbon steel and concrete; waste management; closed-loop systems; plastic recycling; biodiversity; water management systems; even carbon credits (although some believe this is a loophole that should be closed).

Given the transition is being paired with social outcomes; companies might also invest in improving gender and racial diversity; employee housing; health plans; social housing; hospitals; and health solutions. 

Most importantly, investors need to ensure that their funds are spent on projects that are material to the business.

SLF principles and frameworks

The International Capital Markets Association (ICMA) launched the sustainability-linked loan (SLL) principles in 2019, and the sustainability-linked bond (SLB) principles in 2020. 

These principles advise investors on how to structure sustainable loans and issuance. 

They can also be used to help an organisation build its sustainability framework, against which all the organisation’s SLF borrowings are likely to be benchmarked.

That way, it is easier for investors to assess the materiality of a prospective borrower as well as its track record against a baseline.

The principles highlight five core components: selection of KPIs; the calibration of sustainability performance targets (SPTs); bond and loan characteristics; reporting; and verification.

ICMA’s principles advise that the selected KPIs should be relevant to the issuer’s business strategy and core sustainability challenges – hence it must be material. 

The metrics chosen need to be under management’s influence; consistently quantifiable; and able to be verified by an independent third party. 

At the moment, corporations tend to select metrics included in their annual sustainability reports so that investors can gauge progress. Alternatively, companies can provide historical data for the previous three years.

The quality of reporting is considered paramount.

Issuers must commit to publishing relevant updates in relation to the select KPIs and SPTs, including baselines, and they should be consistent and transparent. 

Any information surrounding the ambition of the KPIs is to be viewed favourably.

A second party opinion of an organisation’s sustainability framework is considered a key signal of quality; as is confirmation of compliance with ICMA and the UN’s sustainability goals (SDGs).

Regular external verification of SPTs and KPIs is a must by an auditor or environmental consultant at least annually, at the borrower’s expense.

The three main companies that provide second-party opinions are: ISS ESG; Sustainalytics; and Virgo Elsis. 

Moody’s ESG Solutions says to gain credibility, organisations should report historical KPI performance; use science-based criteria (particularly for emissions); minimise use of carbon offsets; and demonstrate transparency and ambition on scope and coverage.

The more robust the above elements; the more credible the company.

All the KPIs, SPTs, penalties, coupons, loan rates and other determinations should be set in the initial contract.

Not all KPIs and SPTs are created equal

Investors need to keep a keen eye peeled to the substance of KPIs and SPTs given the guidelines for KPI and SPT-selection are voluntary.

Ideally, they should be of high core-strategic and operational value to the business; they must be measurable; externally verifiable and benchmarkable – again material to the business.

In essence, they should provide meaningful mitigation of credit risk to the investor.

But determinations have yet to be made on what “material” and “ambitious” means, so investors need to tread carefully. 

A host of penalty mechanisms 

A key feature of sustainability-linked finance is the penalty mechanism, which provides built-in structural impact and uses “trigger events”’ for failing.

Investors and borrowers have a reasonably broad range of penalty mechanisms from which to choose.

Should a borrower fail to meet its KPIs and SPTs, it will be hit with a penalty – either an increase in the interest rate for the balance of the loan (or a predetermined period); or a straight out charge.

Borrowers can also purchase carbon offsets or make a charitable donation.

In theory, the nature of these two features can vary significantly in terms of reference dates, number of step-ups, size and frequency of charges, and tenor (i.e., whether the penalty is levied at the beginning or end of a loan).

More innovative penalty clauses are likely to develop.

Global Capital says there are two main aspects of penalties: type and magnitude, which we explore in greater depth in the next article on penalties.

The journal notes that SLBs with only one reference date and potential coupon step-up cover about 60% of the market.

SLF Evolution – standardisation the future

At the moment, SLB structures are a bit of a dog’s breakfast but standardisation of contracts should kick in gradually, speeding issuance and boosting volumes

Standardised KPIs are likely to be developed for industries and sectors, based on their respective sustainability challenges. 

For example, carbon intensity is likely to be used as a transitioning measure for energy intensive industries and health and safety as one of several measures for companies such as miners and construction companies.

But until then, it’s something of a wild west and the markets are likely to be experimenting with a range of formats for at least five years.

There is likely to be a divergence in penalty preferences between the SLB and SLL markets.

SLF will become the norm not the exception

Over time, increasing amounts of capital will be linked to sustainability, making sustainability finance the norm rather than the exception.

This suggests that the liquidity of the SLB market will rise rapidly and form an influential and impactful capital base.

So far, only Enel, Italy’s largest sustainable energy company (operating in 30 countries), and oil giant Total have committed to issuing solely SLBs but the mere fact that they have taken such a strident step is a strong sign that more will follow.

Similarly, the SLL market should become an integral component of standard business finance.

The proportion of SLF an organisation carries is likely to become a contributing factor to the numerical ESG scores and ratings attached to each corporation, government and agency issuer.

This will particularly be the case as the world shifts from a 2050 horizon to a 10-15 year horizon.

Innovations in the pipeline

As SLB issuance gains momentum in emerging markets, questions are being asked about the product and its potential for innovation.

The next iteration could see a feature already accepted in the loan market but not yet in bonds: a margin step-down, which we discuss in the next article in this series.

The dearth of supply means that very average issuance is being snapped up.

But as the market matures, offering a smorgasbord of options, investors will be able to afford to be more discriminating and able to select best-in-class peers based on standardised KPIs and SPTs.

 “As the product matures, greater differentiation among SLBs of different tenors and credit quality is likely, notes Global Capital.

“Currently the product’s structure typically defaults to a 25bp step-up in the event of issuers failing to hit KPIs, regardless of other factors.”

“This reflects the relatively immature market. Over times, we expect the financial features of SLBs to become more precise.

“Broader KPI sets appear to be the direction of travel,” says Morgan Stanley’s Cristina Lacaci in Global Capital.

“Over time, we will increasingly see frameworks with several KPIs to address companies’ various priorities.”

A solution to brown transitioners

SLF is not just a tool to drive general sustainability throughout the economy, it is broadly considered a critical tool for financing the brown transitioners.

Brown companies and companies with high fossil-fuel dependence are particularly vulnerable to capital shortages as they transition, given the disruption to their revenue streams and their past heavy reliance on fossil-fuel subsidies.

Use of proceeds (UOP) transition bonds were invented to fill this gap but were found lacking.

UOP fund structures are earmarked for particular projects, which does little to fund a company’s broader shift to improved carbon intensity. 

For example, an oil producer could receive funds for carbon capture storage projects (which are highly dubious), while still racking up a carbon ledger through the rest of the company.

SLF based on standard metrics such as company-wide carbon intensity addresses this problem.

From a borrower’s perspective, having UOP funds earmarked for specific projects, also means the funds are less flexible.

For investors, SLF provides a framework that isolates the poor performers from the good and incentivises strong performance.

Greenwashing – solution or exacerbation

SLF offers a way to mitigate credit risks in an era of tightening ESG-linked regulation (think carbon border mechanisms and rising water costs), that increase operating costs.

To date, a lack of transparency and comparability has allowed greenwashing to flourish, creating serious risks to investors given the growing materiality of sustainability.

Also, use-of-proceeds bonds tend to obscure a company’s broader ESG performance, making recipients appear more worthy than they are.

Some argue that SLFs enhance the prospect of greenwashing given the proceeds can be used for any general purpose. 

Others say that is unlikely given investors are likely to seek opportunities that comply with ICMAs sustainability-linked lending principles and the system will become almost self-regulating.

Greenwashers can represent a double whammy for equities investors in an SLF world. 

If a company fails to meet its SLF KPIs, it is likely to be for a reason that would also generate an equity loss. 

On top of the equity loss, equity investors would then have to pay a premium for failure to the bond investors. 

Sounds like a hedger’s paradise.

Emerging markets and sovereign nations

Companies in wealthy countries have been the main beneficiaries of ESG use-of-proceeds finance to date, given the lack of transparency and wealth in emerging markets.

Critics claim that this state of disproportionate investment has become intractable.

But SLF supporters believe linked finance will help shift this dynamic, given its greater flexibility, comparability and usefulness in transition financing. 

As the Official Monetary and Financial Institutions Forum (OMFIF) puts it:

“We have to move beyond one-off pilot projects and into replicable mainstreaming.”

Supporters say SLF should also entice emerging-market sovereigns, which have been slow to enter the ESG use-of-proceeds market.

A World Bank report found that for low and middle-income countries, returns on responsible investment is high, amounting to US$4 on every US$1 spent on resilient infrastructure.

OMFIF emphasise the risks to sovereigns of not engaging.

“The competitive threats to state-owned enterprises from a global low-carbon transition are massive,” says OMFIF.

“Governments can get ahead of the curve by creating credible plans for integrating low-cost renewable energy into national energy systems, prepare shovel-ready infrastructure projects and make space for private-sector investors in critical areas such as education, health and transportation.”

Speaking in Arabian Business, Chief Sustainability Officer at Majid Al Futtain-Holding, Ibraham Al Zu-bi, describes the next decade as a “use it or lose it” moment for emerging markets to reorient the financial sector towards building a more sustainable and resilient future.

Many doubt that the sluggish sovereigns, concerned about the further financialisation of their economies, will be in a rush to commit taxpayers to SLF financial penalties (we refer you to our previous series on sovereign bonds).

But there appears to be movement at the station, and Morgan Stanley expects to see an inaugural sovereign SLB within the next 18 months, possibly this half.

Supporters of SLF as a tool to support emerging-market companies and sovereigns note that most finance will be attached to eight-10 year KPIs, which will help circumvent election cycles, offering investors more security. 

It would also provide strong economic incentives to both sides of politics to commit to sustainability – pushing policy into the bipartisan arena and providing a monetary balance to lobbying pressure.

A whole new board game for investors

Sustainability-linked finance will add a whole new dimension to investing – a whole new ball game.

The name of this game: Who Cares Wins.

For investors, it will be like graduating from Monopoly to Poleconomy – with a spattering of chess and Twister thrown in.

A working knowledge of 50 shades of green and the socio and geo-political landscapes will help.

It is a game of strategy, risk, timing, information and knowledge; tempered with chance and technology.

A readiness to accept greater risk (investors will need to lean into impact) and sacrifice key pieces will be essential to success.

Having said that, ESG is designed to support the broader economy through the transition so theoretically, the majority of risk lies with the recalcitrant, the ignorant, the complacent and the ostriches.

For most interested but passive investors, a numerical ESG score and credit rating is likely to be allocated to specific investments, simplifying the process.

For active investors, particularly in impact markets, opportunities should abound for those with specialised knowledge in smaller imperfect markets.

Our next article explores in greater depth the step-up, step-down and penalty mechanisms that will drive the game.

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