ESG Focus | Sep 13 2021
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ESG Focus: Linked finance the next big thing – Part 2
Borrowers and investors will confront a range of penalty mechanisms – both in type and size – as sustainability-linked finance floods the market
– Take your pick of type and size of penalties
– More stick than carrot
– Investors and the two-step shuffle
By Sarah Mills
Sustainability-linked finance (SLF) is forecast to rise at a compound annual average growth rate of 98.32% to US$17trn within five years, according to Knowledge Sourcing Intelligence, and this article on SLF penalties is the second in a series on the subject.
Investors and borrowers can take their pick of a variety of penalties, ranging from step-up coupons to charitable donations.
Not all penalties are created equal and some present more risk to investors than others.
A quick recap on SLF
Sustainability-linked finance has been developed to support the green transition and broader social and environmental objectives.
To date, the bulk of ESG finance has comprised use-of-proceeds (UOP) loans such as green and social bonds.
Because UOPs funds were earmarked for specific projects, they lacked flexibility and played to a select few – mainly the energy and materials industries.
They were unsuitable for the vast majority of borrowers that might want to build sustainability into their operations in a more general way.
SLF is best understood as an incentivisation structure: a “pay for success”, “penalise for failure” vehicle that provides funds that can be used for a broad range of social and environmental projects alongside traditional, operational purposes.
SLF borrowers can access these general purpose funds, so long as they meet a set of pre-agreed sustainability key performance indicators (KPIs) and (SPTs).
So for example, a green mortgage is just like a traditional mortgage but a condition of the loan might be that insulation and solar panels be installed, or that the design has a certain carbon quotient, or that water tanks be installed.
If borrowers fail to meet the KPIs and SPTS, penalties apply.
There are two main aspects to penalties: type and magnitude.
Types include step-up and step-down penalties, charges, or obligations to purchase carbon offsets or make charitable donations – and more may develop.
Step-up coupons
The most common penalty type is a one-time coupon/rate step-up applicable to all remaining interest payments on the loan after the first time a borrower misses a target, introducing a time component within the charge.
So it is important that KPI and SPT assessment is conducted at least annually, otherwise the issuer could announce a failure towards the end of loan with no penalty.
At the moment, penalty step-ups tend to range between 10bp and 75bp.
Step-down coupons have also been proposed for outperformance, but the debate to date suggests this is unlikely.
Step-ups and step down coupons mean that sustainability-linked bonds more closely resemble a loan than a bond in that they essentially carry a floating interest rate.
The concept more naturally relates to traditional variable rate loan markets.
Global Capital notes that this structure offers a strong incentive to borrowers to meet targets, but doesn’t incentivise ambitious goal-setting.
Global Capital doubts a step down would be effective in incentivising outperformance given SLBs are, at the moment, already comfortably priced – ditto for sustainability-linked loans.
Some observers believe this could change as the market and pricing matures, to the point that step-downs could represent stretch targets.
The straight-out charge
The next most common penalty type is the “fine” or penalty charge for missed targets.
On the penalty front, this could vary from a fee at the six-monthly/annual assessment of a loan to a one-time payment.
The most common form of penalty for missing SLB targets is the payment of a penalty at maturity.
For example, if an issuer misses a target it must repay more than it borrowed; for example, 100.5% of the principle.
However, there is nothing at this stage stopping a lender from setting a range of fees and penalties over the period of the loan.
Purchase of carbon offsets
Borrowers can choose to mitigate misses by purchasing carbon offsets but this is generally viewed unfavourably for a number of reasons.
For example, it may provide a transitioning “out” for some companies.
Also, carbon offsets could be set, or purchased in advance, and underestimate the necessary amount to make up for the failed SPT.
The Climate Bonds Initiative (CBI) does not consider carbon-offset purchases favourably and this is likely to set the tone for investors and issuers when structuring SLBS.
Charitable donations
Some issuers are already writing charitable donations into their contracts, possibly taking advantage of the demand-supply imbalance in the market.
But charitable donations are also viewed unfavourably by the powers that be because they are not considered material penalties, particularly given the less than altruistic nature of some charities.
It also can be used as a greenwashing tool for the issuer, distracting attention from the more material miss.
And let’s not forget the tax advantages to be gained (an increase in interest expense also creates a tax shield).
An example of what not to do
Morgan Stanley’s report Sustainability-Linked Bonds: Materiality is the Missing Link refers to the recent ANA Holdings’ (a Japanese transportation services company) SLB issuance as an example of what not to do.
It is also an interesting example of what can be done.
ANA Holdings’ SPTs pertain to the environment, human rights, diversity and inclusion, and regional revitalisation.
Its KPIs included:
– listing on the DJSI World and Asia Pacific indices;
– listing on FTSE4Good Index;
– the MSCI Jan ESG Select Leaders Index; and
– a company rating of A- or above on the CDP (a company that administers carbon disclosure ratings).
Morgan Stanley argues that investors aren’t protected against failure in this structure and this type of issuance could prove costly.
Firstly, it had no SLB framework, meaning less transparency, and less comparability with the materiality of its sustainability choices to its core business strategy.
“ANA’s KPIs and SPTs are largely binary and three of the four targets do not appear to be material to the credit in the short or long term,” says Morgan Stanley.
The investment bank prefers internal metrics (particularly those historically reported on) because softer metrics make performance more difficult to quantify.
Also ANA’s penalty for missing the SPT is to donate to charity, which Morgan Stanley decries as irregular, unfavourable to investors, and unlikely to prove a material incentive to the borrower to improve its sustainability.
Similarly, there is poor transparency on the amount donated, so the company may face no consequences for missing targets.
Magnitude of penalty – it must be material
The other key aspect of SLF penalties is that of magnitude.
The magnitude of the penalty is also an important consideration when structuring SLF contracts.
At the moment, 25 basis points is a common number.
But the materiality of such penalties varies according to the underlying coupon.
For example, a 25 basis point penalty on a 1% coupon is more significant than on a 2% loan.
Borrowers with solid sustainability and credit ratings are likely to attract lower relative penalties than underperformers.
Over time, Morgan Stanley expects the pricing on this should tighten according to credit rating and sustainability performance.
Until then, Morgan Stanley offers the following three main considerations to help investors navigate concerns about quality of ESG KPIs and incentives to achieve those targets:
– “Do KPIs reflect a material issue to the credit within the tenor and call structure of the bond?;
– “Is the magnitude of the financial penalty for missing a KPI material within the context of the number of coupon payments post-assessment, size of penalty as a proportion of initial coupon, and sensitivity of the issuer to interest expense?
– “Does the issuer have a track record of corporate reporting and transparency with respect to financials and ESG?"
Investors are also advised to develop a triple scorecard for environment, social and governance performance of a company or organisation.
Another scorecard monitoring water useage, carbon intensity and circularity would make sense.
And as always, be sensitive to greenwashing.
Step down argument
“You wouldn’t praise a fish for swimming”, is one quote being widely bandied around in relation to the concept of step-down coupons.
Step-down coupons are one of the more hotly contested topics in the SLF markets.
They refer to a situation in which a borrower is rewarded for sustainability out-performance by a reduction in the coupon on loan rate.
Step-down supporters say that for issuers, the SLF format offers the prospect of punishment without reward, which could dampen appetite and hold the market back.
They argue that step-down coupons provide an incentive to go above and beyond the KPIs and SPTs outlined in the loan contract.
Supporters also note that without the risk of a step-down, investors might buy weak performers hoping for step-ups, undeservedly lowering cost of capital.
They say that the prospect of step downs should manage that propensity.
Detractors argue that issuers should not be rewarded for doing what they should be doing anyway – hence the fish analogy – and that borrowers are already benefiting from “greeniums” given demand far outstrips supply.
Supporters counter the greenium argument, pointing out the greenium is just a couple of basis points, nothing near the 25bp penalty.
Detractors note that overachieving on the sustainability front would yield cost savings, attracting equity and fixed-income investors, thereby lowering the cost of capital (or raising it on the flipside), or at least prevent it from rising more than that of peers.
This combined with a reputational sheen should provide sufficient incentive to improve environmental credentials.
Detractors argue that step-up coupons without a counterbalancing step-down would not lead investors to favour poor performers, as they would be cutting off their nose to spite their face.
They note that bondholders in particular are more likely to sell out of SLBs that consistently miss targets, rather than hold out for an additional coupon, particularly given missed targets can reflect on broader operational, financial and reputational problems and possible ratings issues.
“It is difficult to make the case that the coupon step-up resulting from not being able to deliver on your ESG commitment is separate from your credit standing as an issuer,” notes Rahul Ghosh of Moody’s ESG Solutions says in Global Capital.
Ghosh notes that trust guidelines may also preclude them from holding consistently underperforming assets, resulting in bond sales at a loss, and the investment fund’s reputation could also take a hit.
“Over time, a failure to hit targets could constrain an issuer’s ability to raise additional ESG financing and have material financial implications above and beyond the 25bp,” says Gosh.
“As that differentiation becomes more apparent in the market, you’ll start to see more variability ex-ante in some of the pricing of the structures.”
Social impact bonds
Meanwhile, the most likely application of a coupon step-down will be in the social impact bond (a form of SLB) market, given investors will be seeking to encourage companies to lean into impact.
Observers point to the development of supercharged impact indices that allow the inclusion of step-down bonds.
Investors will need to learn the two-step shuffle
Life was simple once upon a time – at least simpler.
Accounting for step-ups and step-downs, penalty types and magnitudes is enough to send investors’ head spinning.
It’s a whole new dance – step up, step down, turn around, don't fall down.
Those with deep pockets are likely to manage these gymnastics with greater ease than the minnows, leaving the latter very much in the position of using sustainability reputations as a guide, turning their focus to greenwashing.
The SLF design was intended to help counter greenwashing, which we discuss in a later article.
Frictions in smaller private markets are also expected to favour subject matter experts with a deeper knowledge of the risk and potential surrounding investments.
Over time, credit ratings agencies and sustainability ratings agencies are likely to create a numerical value, which will be attached to corporations and other borrowers to ease the process.
This could extend to specific categories like water, carbon, diversity, safety, given the materiality of KPIs differ from industry to industry and company to company.
In our next article, we turn our attention to the sustainability-linked bond market.
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:
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/
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