Developments in the ESG Bond Market: Sustainability-Linked Bonds and Transition Bonds

That is the third in a sequence of articles wanting on the improvement of ESG in debt financing (the primary and second may be discovered right here and right here). On this article, we have a look at the ESG bond market and focus particularly on sustainability-linked bonds and transition bonds. We’ll focus on the variations between these newer merchandise and the prevailing inexperienced, social and sustainable (“GSS”) bond market and can spotlight the important thing takeaways from trade steerage printed by the Worldwide Capital Market Affiliation (“ICMA”).

What are sustainability-linked bonds?

Following within the footsteps of the sustainability-linked mortgage market, the primary sustainability-linked bond (“SLB”) was issued by Italian vitality distributor, ENEL, in 2019. The ICMA subsequently printed the Sustainability-Linked Bond Principles (the “Rules”) in June 2020 and, extra lately, Q&As to assist the Rules in February 2021.

The primary function of SLBs is that in contrast to `conventional’ GSS bonds, funds raised by means of SLBs aren’t earmarked for particular ESG functions however for common company functions. SLBs give attention to incorporating measurable, forward-looking sustainability key efficiency indicators (“KPIs“) and sustainable efficiency targets (“SPTs”) into the monetary and/or structural traits of bonds. You will need to observe that SLBs needs to be differentiated from sustainable bonds – that are bonds the place the proceeds might be completely utilized to finance or re-finance a mix of each inexperienced and social initiatives, usually according to the ICMA Sustainability Bond Pointers of June 2018.

Following the publication of the Rules, a flurry of SLBs have been issued available in the market, with the latest being trend retailer H&M’s issuance of a EUR 500 million 8.5 yr SLB in February 2021 the place it dedicated to: (i) enhance the share of recycled supplies as inputs to 30 per cent. (from 0.5 per cent.), (ii) scale back Scope 1 and a pair of emissions by 20 per cent., and (iii) scale back (chosen) Scope 3 emissions by 10 per cent.; all towards the 2017 baseline, by 2025. These sustainability-linked devices have are available many types together with an SLB incorporating social targets, a convertible SLB and a sustainability-linked industrial paper programme.

The rise in recognition of SLBs is little question linked to the pliability provided by the unrestricted use of proceeds: all these bonds are sometimes utilized by issuers of their inexperienced or sustainability transition and/or by issuers for whom figuring out adequate environmentally constructive initiatives is probably not possible.

The Rules

The Rules are voluntary tips that suggest structuring options, disclosure and reporting and are relevant to all kinds of issuers and any kind of economic capital market devices. The Rules have 5 core elements:

1. Choice of KPIs

The issuer’s sustainability efficiency is measured utilizing sustainability KPIs. The KPIs needs to be related, core and materials to the issuer’s general enterprise, and of excessive strategic significance to the issuer’s present and/or future operations. They need to be measurable, externally verifiable and able to being benchmarked. Issuers are inspired, when potential, to pick out KPI(s) that they’ve already included of their earlier annual reviews, sustainability reviews or different non-financial reporting disclosures to permit buyers to guage historic efficiency of the KPIs chosen.

2. Calibration of SPTs

SPTs have to be set in good religion and the issuer ought to disclose strategic data that will decisively influence the achievement of the SPTs. The SPTs needs to be formidable (symbolize a fabric enchancment within the respective KPIs and be past a `enterprise as regular’ trajectory) and be per the issuers’ general strategic sustainability/ESG technique. They have to even be decided on a pre-defined timeline which is ready earlier than (or concurrently with) the issuance of the bond.

An exterior assessment (akin to a second get together opinion) to substantiate alignment of the bond with the 5 core elements of the Rules is really helpful.

3. Bond traits

The bond ought to embody a monetary and/or structural influence involving set off occasion(s). On more moderen SLBs, this has predominantly been within the type of a coupon step-up (usually between 10 to 75 foundation factors), though some issuers have provided a premium cost as a substitute. Because the market evolves, will probably be fascinating to see if extra progressive penalty clause constructions are embedded into bonds.

4. Reporting

Issuers ought to publish often, and at the least yearly, (i) up-to-date data on the efficiency of the chosen KPI(s), (ii) a verification assurance report relative to the SPTs outlining the efficiency towards the SPTs and the associated influence (and timing of such influence) on the bond’s monetary and/or structural traits, and (iii) any data enabling buyers to watch the extent of ambition of the SPTs.

5. Verification

Issuers ought to, at the least yearly, search impartial and exterior verification of their efficiency stage towards every SPT for every KPI by a certified exterior reviewer with related experience, akin to an auditor or an environmental marketing consultant.

The rise in recognition of SLBs

Excellent SLBs reached over USD 10 billion in 2020 following the discharge of the Rules and the SLB bond market is predicted to develop even additional in 2021. The pliability to make use of KPIs to suit an issuer’s particular sustainability technique has been effectively acquired by the market and the structural potentialities of SLBs has made the format extra engaging to a wider vary of issuers than the GSS bond market. The truth that the failure to satisfy SPTs acts as a set off occasion has been seen as engaging to buyers, though some have questioned whether or not rewarding buyers for a failure to satisfy targets is the best method. Market contributors have additionally flagged the chance of `greenwashing’, arguing that the shortage of transparency round an SLB’s use of proceeds may create a legitimacy difficulty for the market.

SLBs additionally current a further alternative for the buy-side to allocate capital to satisfy their ESG funding targets, notably as there’s a such excessive demand for eligible financing alternatives. This has been evident within the current SLBs which have come to market which have all generated vital curiosity from a variety of buyers and have been oversubscribed.

This attractiveness of SLBs is prone to be bolstered this yr following the announcement by the European Central Financial institution in September 2020 that bonds with coupon constructions linked to sure sustainable efficiency targets will change into eligible as collateral for Eurosystem credit score operations and likewise for Eurosystem outright purchases for financial coverage functions from 1 January 2021, offered they adjust to all different eligibility standards.

Because the SLB market grows, it would even be fascinating to see the interaction between SLBs and regulatory frameworks. For instance, underneath the EU Taxonomy, sure corporates and banks might be required sooner or later to reveal the share of their EU Taxonomyaligned enterprise actions. Consequently, issuers of SLBs in Europe are being inspired to reference and benchmark their sustainability efficiency towards the EU Taxonomy’s technical screening standards (which is underneath improvement), which can even be utilized as KPIs or the SPT calibration for such an issuance.

Financing brown to inexperienced: Transition Bonds

While the launch of the Rules was welcomed by issuers and buyers, the debt capital markets additionally recognised that additional steerage was wanted for transitioning issuers. These are issuers who’re on a transition pathway to Paris Settlement targets and want to increase funds with a purpose to assist them obtain emission discount targets. Beforehand, a handful of transactions carried the transition label, nonetheless, there was no singular definition of a `transition bond’. This ultimately led to the publication of the ICMA Climate Transition Finance Handbook (the “Handbook”) and associated Q&As in December 2020. Apparently, the Handbook doesn’t set out detailed ideas in the identical method because the ICMA Inexperienced Bond Rules or the Rules. As a substitute, issuers are inspired to make use of present instruments (i.e. take into account a GSS bond if an issuer needs to allocate capital to a devoted use of proceeds or difficulty an SLB with a purpose to obtain designated ESG aims) and use the Handbook as an additional layer of issuer-level steerage for issuers searching for to align their financing technique to their local weather transition targets and decarbonisation trajectory. You will need to emphasise that the Handbook is simply related when elevating funds for local weather transition-related functions. Issuers who want to set different sustainable or social targets don’t have to look to the Handbook for steerage, however can in fact accomplish that to lend credibility to their related transition methods.

The Handbook

There are 4 key parts to the Handbook suggestions, that are outlined beneath.

1. Issuer’s local weather transition technique and governance

The idea of local weather transition focuses principally on the credibility of an issuer’s local weather change-related commitments and practices. A transition label utilized to a bond ought to serve to speak the implementation of an issuer’s company technique to remodel the enterprise mannequin in a method which successfully addresses local weather associated dangers and contributes to alignment with the targets of the Paris Settlement. Disclosures concerning company methods could also be aligned with recognised reporting frameworks, such because the suggestions of the Activity Power on Local weather-Associated Monetary Disclosures (“TCFD”), or related frameworks. An impartial technical assessment of the issuer’s technique might help buyers in creating a view concerning its credibility.

2. Enterprise mannequin environmental materiality

An issuer’s deliberate local weather transition trajectory needs to be related to the environmentally-material elements of the issuer’s enterprise mannequin, bearing in mind each present and future situations which can influence on present determinations concerning materiality. The local weather transition trajectory, so far as it pertains to financing, needs to be a fabric issue to the long run success of the enterprise mannequin, versus being an incidental facet.

3. Local weather transition technique to be `science-based’, together with targets and pathways

An issuer’s local weather technique ought to reference science-based targets and transition pathways. Particularly, it needs to be (i) quantitatively measurable (primarily based on a measurement methodology which is constant over time), (ii) be aligned with, benchmarked or in any other case referenced to, recognised, sector-specific science-based trajectories (the place they exist), (iii) be publicly disclosed (ideally in mainstream financing filings) and embody interim milestones, and (iv) be supported by impartial assurance or verification.

4. Implementation transparency

Issuers ought to, to the extent practicable, present transparency on the funding programme underlying its local weather transition technique, as it’s this programme which underpins the success or failure of any such technique. Issuers ought to disclose particulars of capital and operational expenditure, particulars of the place any such working expenditure is deemed `nonbusiness as regular’, particulars of divestments, governance, course of change, in addition to different related data indicating how this programme helps implementation of the transition technique.

The case for Transition Bonds

Up till lately, the ESG debt capital markets have been targeted on GSS bonds and inexperienced industries who’re already on their technique to lowering emissions. Nevertheless, hard-to-abate sectors, accounting for a major proportion of complete emissions, have the best influence to make and due to this fact type the most important piece of the puzzle with regards to lowering GHG emissions. It’s effectively recognised that efforts to transition to low-carbon economies have to be ramped up considerably with a purpose to attain these targets and transition bonds may have a vital function to play, notably as regulators mount strain on firms to quickly handle local weather change.

In fact, as with SLBs, there are some issues in regards to the potential for `greenwashing’ being better within the transition area as what constitutes a real transition and applicable science primarily based targets will differ from sector to sector. The Handbook can go a great distance in the direction of offering standardisation and transparency to the market and can give issuers in carbon intensive sectors a chance to lift finance to assist their local weather transition technique in a reputable method. While the market remains to be at a nascent stage, the publication of the Handbook has generated widespread curiosity. Asia, particularly, has seen two current transition bonds come to market: Financial institution of China priced a transition bond from its Hong Kong Department in two tranches (USD 500 million 3 yr and CNH 1.8 billion 2 yr) in January and Hong Kong’s Fort Peak Energy Firm issued its third transition bond (USD 300 million 10 yr) in February 2021.

Traders too are more and more understanding the essential function `brown’ sectors should play in assembly emission discount targets and are keen and prepared to assist corporates obtain their sustainability targets. Inventory exchanges can also be beginning to recognise this significance, with the London Inventory Trade launching a devoted Transition Bond Section in February 2021 – the primary trade globally to take action (complementing its present Inexperienced, Social, Sustainability and IssuerLevel segments).

Conclusion

Regardless of the yr’s myriad of challenges, the ESG bond market has made enormous strides in 2020 with the appearance of the Rules and Handbook. There was recognition available in the market that while GSS bonds have performed a really massive function in financing environmentally pleasant and social influence initiatives, extra must be performed to supply alternatives to `brown’ issuers who’ve the ambition to transition to inexperienced sooner or later. By complementing GSS bonds, SLBs and transition bonds ought to allow extra issuers to faucet the ESG bond market and scale up decarbonisation, whereas serving a broader vary of buyers. As political and societal give attention to the local weather disaster and ESG extra broadly is at an all-time excessive, notably with the goal of a `inexperienced restoration’ following the Covid-19 pandemic, these new merchandise and steerage have come at an opportune time to assist create actual and lasting change.