In September 2019, Enel Finance International NV (Enel Finance), the Dutch-registered finance subsidiary of the Italian energy group Enel, structured and issued the first-ever Sustainability-Linked Bond (SLB) (the Enel USD SLB), borrowing the concept from the already developed sustainability-linked loan market and applying it to a bond issue. The new structure was well received by the market, with the deal being oversubscribed by almost three times. Enel followed the Enel USD SLB with the issue in October 2019 of a €2.5 billion multitranche SLB.1 To date, there have been no other issuances of SLBs.

In January 2020, the Executive Committee of the Green Bond Principles, the Social Bonds Principles and the Sustainability Bond Guidelines (the Principles), supported by the International Capital Markets Association (ICMA), established the Sustainability-Linked Bonds Working Group (the SLB Working Group). The SLB Working Group’s remit is to analyze the emerging sustainability/key performance indicator (KPI)-linked bond product and to propose market guidance building on existing developments in the sustainability-linked loan market.

On June 9, 2020 the SLB Working Group published the Sustainability-Linked Bond Principles (SLBP).

We have set out below our thoughts regarding some of the advantages and disadvantages of SLBs and whether the SLBP will help overcome the perceived obstacles of using this structure as a means to raise finance.

What are SLBs?

The SLBP document defines SLBs as follows:

SLBs are any type of bond instrument for which the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined sustainability/environmental social or governance (ESG) objectives. In that sense, issuers are thereby committing explicitly (including in the bond documentation) to future improvements in sustainability outcome(s) within a predefined timeline.

In contrast to Green, Social and Sustainability Bonds, where the issuer commits to earmark the proceeds of the issue of the bonds to specific projects and assets with ESG benefits in line with the applicable Principles, an SLB issuer can use the proceeds of issue for its general corporate purposes. However, where certain predefined ESG focused targets are not met within an established timeframe, the economic characteristics (or the structural characteristics) of the bond will change such that they are less favorable for the issuer.

Under the terms of the Enel USD SLB, if the Enel Group does not achieve a percentage of installed renewable generation capacity (on a consolidated basis) equal to or greater than 55% of total consolidated installed capacity by December 31, 2021, the coupon for the bond will step up, increasing the rate of interest by 25 basis points. The issuer can use the proceeds of the issue for its ordinary financing needs as long as the group’s overall strategy complies with the predetermined targets.

What are the SLBP?

The SLBP document states:

The Sustainability-Linked Bond Principles are voluntary process guidelines that outline best practices for financial instruments to incorporate forward-looking ESG outcomes and promote integrity in the development of the SLB market by clarifying the approach for issuance of a SLB.

The SLBP are intended for broad use by the market: they provide issuers with guidance on the key components involved in launching a credible and ambitious SLB; they aid investors by promoting accountability of issuers in their sustainability strategy and availability of information necessary to evaluate their SLB investments; and they assist underwriters by moving the market towards expected approaches to structuring and disclosures that will facilitate credible transactions.

The SLBP are based on five core components:

  1. Selection of KPIs: Sustainability-focused KPIs can be either external or internal and should be relevant and material to the issuer’s sustainability and business strategy. These should also be measurable, quantifiable, externally verifiable and able to be benchmarked, using external references to the extent possible.
  2. Calibration of Sustainability Performance Targets (SPTs): One or more SPTs per KPI should be established, and the issuer should disclose strategic information that may decisively affect the SPTs. The SPTs must be ambitious, and the issuer should demonstrate that they aim at a material improvement beyond “business as usual” on each particular KPI. The SPTs should, where possible, be compared to a benchmark or an external reference, be consistent with the issuers’ overall strategic sustainability strategy and be determined on a predefined timeline, set before (or concurrently with) the issuance of the SLB.
  3. Bond characteristics: The SLB will need to include financial and/or structural consequences of failing to meet the SPTs, involving trigger events(s) where the SPTs are not met, for example a coupon step-up. Such changes should be commensurate and meaningful to the characteristics of the bonds.
  4. Reporting: The SLPB require preissuance and postissuance reporting, the latter to occur at least on an annual basis whereby investors should be informed of the issuer’s performance in respect of the selected KPIs.
  5. Verification: Issuers should seek independent and external verification (e.g., limited or reasonable assurance) of their performance level against each SPT for each KPI by a qualified external reviewer with relevant expertise, at least once a year, and in any case for any date/period relevant for assessing the SPT performance leading to a potential adjustment of the SLB financial and/or structural characteristics until after the last SPT trigger event of the bond has been reached. The verification should be made publicly available. This postissuance verification (in contrast to preissuance external review; see below) is a necessary element of the SLBP.

The SLBP recommend that, in connection with the issuance of an SLB, issuers should appoint one or more external review providers to confirm the alignment of the bond with the five core components set out above. Further guidance is provided on the assessments to be made by such external reviewers for a preissuance second-party opinion. Where an issuer does not seek a second-party opinion, it is recommended that the issuer demonstrates or develops the internal expertise to verify its methodologies, to be documented and communicated to investors.

What are the advantages of SLBs?

  • General corporate purposes use of proceeds: Unlike with a traditional Green Bond, the SLB issuer is free to use the proceeds for its general corporate purposes and is not required to ring-fence or track the net proceeds of the bond to be allocated to eligible green projects or assets. This leaves the issuer with the freedom to pursue its own sustainable and corporate strategy.2
  • Investor diversification: SLBs arguably attract socially responsible investors (SRIs). However, investors with a narrow mandate to invest in green assets3 might not be able to invest in SLBs, given that the proceeds of an SLB issuance need not be earmarked to acquire/finance green assets or invested in green projects.
  • Available to a broader range of issuers: Many potential issuers will not have sufficient existing or anticipated green assets to justify the issue of a Green Bond. An SLB gives such issuers the opportunity to address the sustainability performance of the organization and participate in a diversified market without requiring them to purchase a significant amount of green assets.
  • Sustainability strategy of the issuer as a whole: One weakness of Green Bonds is that they are limited to a subset of the issuer’s activities linked to the green assets acquired/financed with the proceeds of the Green Bond. They do not necessarily address the overall strategy of the organization and its performance against defined ambitious targets. Green Bonds are rarely used to finance activities that the issuer is not already undertaking; one could argue that Green Bonds do not necessarily facilitate an issuer becoming greener. In contrast, a SLB specifically focuses on the issuer’s overall sustainability strategy as whole and, if the SLBP are appropriately applied, will require that issuer to set goals that go beyond the status quo.

What are the disadvantages of SLBs?

  • Investor diversification: As discussed, while SRIs would be interested in SLBs, most Green Bond dedicated funds would not be able to acquire such an instrument, as the use of proceeds is not clearly earmarked for green investments. Given the novelty of these instruments, it remains unclear which investors will genuinely be interested in such structures.
  • Open to public scrutiny: Sustainability-linked loans have proven a popular way to raise finance but are private contracts. SLBs are by their nature public. Accordingly, if the issuer sets the bar too low in terms of KPIs, in addition to arguably not satisfying the SLBP by not setting an ambitious enough target, it may open itself to criticisms of “green-washing” from the market. On the other hand, issuers might be wary of setting the target too high and risk triggering the financial or structural “penalty” changes in the SLB (e.g. a coupon step-up), when there is still no clear pricing advantage in issuing a SLB compared to more traditional fixed or floating rate bonds that have no ESG element.
  • ECB eligibility: SLBs structured with a coupon step-up would not be eligible to be purchased by the European Central Bank (ECB) as part of either its Pandemic Emergency Purchase Program (PEPP) or the Corporate Sector Purchase Program (CSPP); that is because the ECB is unable to purchase bonds with coupon pricing risk, including step-ups. Lack of such eligibility has potential adverse marketing implications when markets are performing normally, and such concerns would likely be exacerbated in the current economic environment surrounding the Covid-19 pandemic.

Will the SLBP incentivize the issue of SLBs?

The publication of the SLBP is likely to have a positive impact on the use of SLBs. By providing a framework and definitional structure for these new products, it should make issuers more comfortable with issuing SLBs. At the same time, the SLBP provide investors with a set of guidelines against which prospective investments can be assessed. When the Enel USD SLB was issued, it attracted significant market attention, and indeed the SLB Working Group was established specifically to assess the viability of this new product and draw up a set of voluntary principles.

Given the high profile and publicity of the Enel SLBs, it might seem surprising that no other issuer has issued a SLB. One reason could be that issuers might have wanted the SLB Working Group to develop guidelines before utilizing such a new structure. It is to be hoped that the SLPB Principles will provide reassurance to address some of the concerns raised above, but the lack of eligibility for the ECB’s asset purchase schemes may well continue to present a significant obstacle to development of the market. The challenge will be for issuers to structure SLBs in such way that they satisfy PEPP or CSPP eligibility criteria (e.g., by not relying on coupon step-ups but rather on other structural changes that operate as penalties to noncompliance). Absent such developments, the risk is that this will remain a small market, mainly available to high-yield issuers whose bonds would not be ECB eligible in any case.