Sustainability-linked bonds – their potential to promote issuers’ transition to net-zero emissions and future research directions

ABSTRACT

Sustainability-linked bonds (SLBs) promise to complement the use-of-proceed model of green bonds by tying general purpose debt finance to issuers’ sustainability performance against predefined targets. In this commentary, we highlight that the potential of SLBs to promote issuers’ climate transitions crucially depends on a common understanding of eligible economic activities and material performance indicators, the use of science-based targets as best practice, the ability of borrowers to dispel concerns about greenwashing risk, and bond characteristics that set meaningful incentives for issuers to improve their carbon performance. Future research should investigate the climate-related additionality of SLBs, assess if bond characteristics and changes in capital costs support issuers in meeting or even increasing their climate targets and deter unsustainable investments, and better understand the challenges and opportunities for the SLB market to bring about system-level innovation to the financial system.

KEYWORDS:

• Transition finance
• sustainable debt
• sustainability reporting
• financial innovation

1. Introduction to sustainable-linked bonds

According to Caldecott, green financial instruments must meet two key criteria to contribute to the transition of the real economy to environmental sustainability (Caldecott 2020). First, economic activities that an instrument is encouraging should be (or be able to become) compatible with the goal of the Paris Agreement of limiting global warming to well below 2°C and preferably to 1.5°C (Caldecott 2020). Second, the instrument must make a clear and measurable difference in the real economy by, among other things, helping borrowers in managing climate-related risks, enabling them to align their practices to a zero emissions future, and by reducing the cost of capital for activities that are compatible with the Paris Agreement (Caldecott 2020).

Real economy in this context refers to the part of the economy that concerns the production, transportation and purchase of goods and services, rather than the exchange of financial assets like currencies or stocks which is the concern of the financial economy (Sloman, Garratt, and Guest 2018). Changes in the real economy that sustainable finance instruments are expected to promote aim at the full decarbonization of the power and heating sector, heavy industry, transport, manufacturing, construction, land use or real estate. Thus, better scientific understanding is needed about the contribution that sustainable finance instruments make to the transition of the real economy to net-zero emissions.

This article comments on the potential of sustainability-linked bonds to contribute to the decarbonization of the real economy and proposes directions for future research. Sustainability-Linked Bonds (SLBs) are the newest addition to the growing market of sustainability-themed debt instruments.¹ The International Capital Market Association (ICMA) defines SLBs as ‘[…] any type of bond instrument for which the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined Sustainability/ ESG objectives’ (ICMA 2020a, 2). Since the issuance of the first SLB by utility company Enel in September 2019, more than USD 125 billion of this type of bond have been raised.² In comparison, cumulative issuance of green, social, and sustainability bonds reached USD 1,758.6 billion, USD 407.9 billion, and USD 336.7 billion, respectively through 2021.³ Europe is currently the leader of the SLB market with more than USD 73.5 billion in total issuance, followed by North America with USD 19.4 billion, Asia with USD 13.1 billion, South America with USD 8.8 billion, Oceania with USD 3.6 billion with the Middle East and Africa accounting for the remaining USD 6.6 billion.⁴

We choose to comment on the potential of SLB to promote issuers’ transition towards carbon neutrality for four main reasons. First, SLBs make up the fastest growing segment of the sustainable bond market with the total of new issuances in 2021 being 8.5 times higher than the compared the year before.⁵ In comparison, the total market for sustainable debt finance grew by 115percent in 2021.⁶

Second, as we outline below, the performance-based structure of SLBs markedly differs from the use-of-proceeds structure of established green, social, and sustainable bonds. This makes a closer investigation of the unique structural traits of SLBs necessary to better understand their potential contribution to the transition of the real economy.

Third, SLBs are becoming quickly recognized by regulators and future regulatory efforts are aimed at growing the market even further. In September of 2020, the European Central Bank made the decision to accept SLBs as collateral.⁷ The European Commission has also announced that it will develop a sustainability-linked bond label as part of its renewed sustainable finance strategy.⁸ There are also some initial discussions among experts about linking sovereign debt in developing countries with national sustainability commitments (Stewart and Anderson 2021; Elwin et al. 2021). Public policy research is needed to inform regulatory action on and potential sovereign issuance of SLBs.

Fourth, although SLBs have been dubbed the next frontier in sustainable finance (Giráldez and Fontana 2021), academic research on this new instrument is still scarce. Thus, there is a need to develop directions for future research on SLBs.

2. Differences between use-of-proceeds bonds and performance-based SLBs

There are notable differences between SLBs and other labelled debt instruments. In the case of green, social, or sustainability bonds, issuers commit to using the proceeds of such bonds to exclusively finance or refinance projects that have a positive environmental or social impact (ICMA 2019). In contrast, the proceeds of SLBs are used for general purposes in support of issuers’ objectives for future improvements in sustainability performance. Put differently, SLBs are general debt instruments which offer issuers a lower cost of capital if they achieve predefined sustainability targets. Unlike use of proceeds instruments, SLBs can be used to finance investments in projects that are not considered green under the condition that issuers improve their overall sustainability performance. Tenures of the most recent SLBs range from 5 years for a bond issued by mining company SSAB⁹ to 12 years for a recent transaction from oil company Repsol.¹⁰

According to the ICMA’s Sustainability-linked Bond Principles (SLBP), progress on sustainability performance by SLB issuers is measured through Key Performance Indicators (KPIs) and assessed against Sustainability Performance Targets (SPTs) (ICMA 2020a). The key innovation that SLBs are bringing to the sustainable debt market, however, is that the bond’s characteristics (e.g. coupon, maturity, repayment amount) can vary depending on whether the selected KPIs achieve predefined SPTs. Issuers are also asked to report on the performance of KPIs against SPTs and to seek independent and external verification of their reporting.

Coupon ratchets are currently the most common performance-based adjustments to SLB characteristics (Ramel and Michaelsen 2020). In the case of Enel, failure of the company to increase the share of renewables of installed capacity to 60 percent by 2022 would lead to a one-time coupon step-up of 25 bp (Enel Group 2020). However, when SPTs need to be achieved close to the maturity date of the bond, issuers and investors of SLBs have chosen performance-linked characteristics that are different from coupon ratchets. In January 2020, the shipping company Odfjell issued a SLB of NOK 850 million with a four-year maturity term (Jensen and Sannem 2021). The redemption price of the bond is linked to the company improving its Average Efficiency Ratio (AER) to 8.18 or lower by June 30, 2024 (Jensen and Sannem 2021). If Odfjell fails to meet the AER target and/or fails to deliver the supporting verification and review, there will be an increase in the redemption price of the bond by 150bps (Jensen and Sannem 2021).

3. How can SLBs encourage investments in zero-emission activities?

Notably, the SLBP do not include a list of eligible project categories like the principles for green, social, or sustainable bonds. Instead, the SLBPs state that KPIs should ‘be material to the issuer’s core sustainability and business strategy and address relevant environmental, social and/or governance challenges of the industry sector’ (ICMA 2020a, 3). Hence, issuers’ SPTs should represent an ambitious improvement in the respective KPIs and should be based on external benchmarks. However, the SLBP do not include a definition of ‘material’ or ‘ambitious’ KPIs or SPTs for specific sectors or sustainability issues.

Governments and regulators could strengthen the credibility and growth of the market by clarifying investment priorities that are coherent with long-term sustainability and climate targets (Shishlov, Morel, and Cochran 2016). At least in the European market, the EU taxonomy of sustainable economic activities which entered into force in 2020 (Regulation (EU) 2020/852) has the potential to support issuers and investors in defining material KPIs and ambitious SPTs. First, the taxonomy can be used to determine if the economic activities of a potential issuer of an SLB are ‘eligible’ ‒ i.e. if the activities are aligned with one or more of the EU’s six environmental objectives.¹¹ Second, issuers of SLBs could use the taxonomy’s technical screening criteria to benchmark their sustainability performance and to calibrate their performance indicators and targets and (ICMA 2021). Technical screening criteria for climate change mitigation and adaptation were formally adopted by the European Commission in June 2021 (EC 2021). Proposals for technical screening criteria for the remaining environmental objectives will be put forward by the European Commission in 2022.¹²

However, observers of the EU taxonomy have pointed out that technical requirements for transitional activities should be clearer and more stringent to ensure that lock-in of carbon intensive economic activities are avoided and that credible pathways to climate neutrality are promoted (Maltais, Vulturius, and Tuhkanen 2020). The dual task of finding common standards for defining material indicators and agreeing on sustainability targets that should be considered as sufficiently ambitious for SLBs is likely to become even more complicated as work on a ‘common ground taxonomy’ involving the EU and China is taking shape (Rust 2020).

The issue of lacking definitions of ‘material’ KPIs, ‘ambitious’ SPTs and investment priorities in the SLB market is particularly pressing when it comes to climate action. This is because close to 82 percent of the total value of all SLBs issued to date are linked to reducing greenhouse gas emissions.¹³ Thus, actors in the SLB market working with climate targets still need to agree on which activities are aligned with Paris Agreement, which are not, and which activities are eligible now but need to be phased out in the future to keep issuers’ emissions on a Paris-aligned trajectory, particularly in hard-to-abate sectors. Shared understandings of eligibility will also be important for other dimensions of sustainability such as circular economy, recycling, or gender equality in management, which are included in six percent, seven percent, and four percent of SLBs by total value, respectively.¹⁴

4. To what extend can SLBs help issuers manage climate-related risks and align their emission trajectory with the Paris Agreement?

The green bonds market offers several important lessons to assess the potential of SLBs to promote issuers’ transition toward zero-emissions. Tuhkanen and Vulturius (2020) have made the argument that if green bonds are linked to science-based targets and conduct transparent impact reporting they can be an important tool for issuers to transition to net-zero emission activities and to show to their investors that they are managing their climate risks. However, the authors found that linking green bonds to science-based targets and transparent impact reporting is not common practice among the largest European issuers. This suggest that even in the leading green bond market, it is still not common to integrate sustainable debt into corporate climate strategy and investor relations.

Observers of the sustainable debt market have also argued that the credibility of the green bond market is called into question if issuers continue to use general purpose financing to invest in projects that are diametrically opposed to international climate targets (Erlandsson 2020). Specifically, critics have contended that the green bond market is exposed to greenwashing risk because issuing a green bond doesn’t require the borrower to make any sustainability improvements that are not included in the bond’s underlying use-of-proceeds framework (Caldecott 2020).

The ICMA has made two key provisions for how SLBs can address the criticisms that have been levied against green bonds. First, unlike green bond which focus only on proceed-based financing of eligible projects, SLBs are intended to be used for general purpose financing under the condition that issuers make material and ambitious improvements to their overall sustainability performance beyond a ‘Business as Usual’ trajectory. To that effect, the SLBP call on issuers to set SPTs based on a combination of benchmarking approaches, including (a) Issuer’s own performance against KPIs over time for which a minimum of 3 years, and (b) The SPT’s relative positioning versus its peers’ or current industry or sector standards, and/or (c) Reference to science (e.g. science-based scenarios), or to policy targets (e.g. Paris Agreement or Sustainable Development Goals), or to recognized best-available-technologies (ICMA 2020a).

Second, to improve the credibility of SLBs and other sustainable debt instruments, the ICMA has defined recommendations for issuers wanting to attach a transition label to their bonds (ICMA 2020b). According to ICMA, transition bonds can be either green bonds or SLBs that are issued by those looking to ‘align their financing strategy to their climate transition strategy and decarbonisation trajectory’ (ICMA 2021, 2). Specifically, issuers wanting to apply a transition label to their bonds are recommended to disclose externally verified information about their climate transition strategy and governance and the environmental materiality of their planned business transition.

Notably, ICMA recommends using science-based emission reduction targets to ensure that issuers of SLB reduce their carbon emissions in line with the Paris Agreement. The SLBP determines that setting SPTs regarding emission reduction should be based on a combination of benchmarks including science-based scenarios, absolute targets, or official national/international targets (ICMA 2020a). Similarly, ICMA also recommends that the climate strategy of transition bond issuers should reference science-based targets noting that ‘a 1.5°C trajectory will be perceived as most credible to the increasing proportion of market participants’ (ICMA 2020b, 5).

Several issuers of SLBs, including the clothing company H&M¹⁵, the Scottish utility SSE¹⁶, and the food retailer Tesco¹⁷ have linked their issuances to science-based targets. Setting emissions reduction targets is increasingly recognized as an effective corporate climate risk management response to reduce transition risk (Sakhel 2017) and improve carbon performance (Dietz et al. 2018). Although the connection between emissions reduction targets and actual emissions is understudied (Ioannou, Li, and Serafeim 2016), existing studies suggest a positive relationship between carbon performance and ambitious long-term targets (Dahlmann, Branicki, and Brammer 2019; Ioannou, Li, and Serafeim 2016). Findings from the Science-Based Targets initiative (SBTi 2021) show that companies that have adopted emission reduction targets have reduced their scope 1 and 2 emission at an annual rate of 6.4 percent between 2015 and 2019.

Thus, linking bonds to issuers’ performance against climate targets is of key importance for the credibility of the SLB market. The increasing pressure that investors are putting on issuers of sustainable debt to adopt ambitious emission reduction targets (Amundi 2021) and their concerns about greenwashing risk suggest that science-based targets will become a standard feature at least for issuers that are exposed to material transition risk (CDP 2021). Investor demand for science-based targets also suggests that the market for SLBs can incentivise issuers to align their emission to the Paris Agreement.

However, there are also several risks related to the SLB markets reliance on science-based targets. First, while science-based target setting is generally accepted as an adequate approach to determine emission reductions under carbon budget constraints (Walenta 2020), the method is not free from controversy as a recent disagreement between the founders of the SBTi have shown (Wodall 2020). This disagreement was about the question of what constitutes science-based climate targets for financial institutions and about the tentative link between sustainable investment strategies and changes in investees’ economic practices and carbon performance (see Kölbel et al. 2020).

Second, adopting climate targets does not automatically mean that issuers change their business strategy and make necessary investments needed to meet these targets (Walenta 2020). Third, knowing if issuers of SLBs are ‘on track’ to meet their science-based targets depends on transparent, methodologically robust, and harmonized reporting that is accessible to both investors and market observers. It remains to be seen if reporting requirements defined in the SLBP will mitigate the risk of poor reporting of sustainability performance against science-based targets.

5. What is the likely impact of SLBs on issuers’ cost of capital and how will the market address investors’ preferences and concerns?

Market data suggests that issuers of sustainable debt on average have slightly lower borrowing costs compared to standard bonds (Slimane, Da Fonseca, and Mahtani 2020). Similarly, academic research has shown that investors in green bonds are willing to pay a premium – i.e. ‘greenium’ – of between two (Zerbib 2019) and eighteen basis points (Gianfrate and Peri 2019). For issuers this means that they can receive a lower cost of capital for activities that can help them transition to zero emissions.

While the market for sustainability-linked debt is still too small to draw conclusions about the cost of capital, recent deals suggest that issuers of SLBs cannot expect to automatically receive the same price discounts that investors are giving to green bonds. A comparison of the spread – i.e. the difference in the yield – between recently issued SLBs and non-SLBs of three investment-grade corporations showed that the SLBs pricing was in line with the issuers’ traditional bonds (NN Investment Partners 2021). Evidence of a ‘greenium’ for SLBs maybe stronger in the high-yield sector. Recent deals from glass packaging firm Verallia Société Anonyme or pharmaceutical company Lonza Group suggest that issuers of performance-based bonds have enjoyed pricing benefits comparable to premiums observed in the green bond market (Flitman 2021). In the case of Verallia Société Anonyme, the company issued a EUR 500 million SLB in 2021 with a yield of 1.625percent compared to an average yield of 1.940 for bonds of the same BB+ rating.

The extent to which the ‘greenium’ effect will carry over into the SLB market crucially depends on investors preferences and risk perception. Experience from the green bond market suggest that investors are willing to accept lower yields if they consider bonds to respond to their sustainability-related considerations (Maltais and Nykvist 2020) and perceive issuers to have lower risk and better financial performance due to increased transparency (Sartzetakis 2020).

A recent survey of global investment managers suggests that SLBs are seen by a majority of investors as fitting into most investment strategies including green bond funds and ESG integration strategies focusing on energy transition and climate change (Natixis 2021). However, the same survey also showed that investors are concerned about greenwashing risk of SLBs. Notably, some of the most prominent early investors in green bonds have criticized SLBs for their of lack of transparency on how proceeds contribute to improvements in issuers’ sustainability performance, that SPTs can be gamed to make them more easily achievable, and that performance-based coupon step ups and are not steep enough to incentivise issuers to priorities targets (Liberatore 2021). These concerns by investors need to be better understood to gauge the potential impact of SLBs on the cost of capital for activities that help issuers’ achieve net-zero emissions.

We argue that there are four critical points that affect investor demand and eventually the pricing of SLBs. First, issuers of SLBs can benefit from lower cost of finance while retaining full discretion for how capital will be allocated once it has been raised. Compared to green bonds investor have much less control and insights over how the proceeds of the bonds are used and what specific outcomes they delivered. There have been several recent issuances where the credibility of issuers’ transition strategy and environmental targets have been called into question.¹⁸ It is possible that the ‘greenium’ of SLBs will suffer as more and more investors are getting worried about their exposure to greenwashing risk. Investors may also start to require specific information and assurances about the impact of their investment on issuers’ sustainability performance.

Second, concern about issuers ‘gaming’ sustainability targets highlights the need for commonly accepted and science-based benchmarks to define ambitious sustainability targets and material performance indicators. As the diversity of issuers of SLBs grows, so does the number of sustainability issues with less-established metrics and benchmarks such as biodiversity or social equality. Thus, defining, and harmonizing sector- and context-specific KPIs and SPTs and raising awareness about them and will become an increasing challenge for the SLB market.

Third, the potential of SLBs to set incentives for issuers to achieve sustainability targets will critically depend on bond characteristics. Coupon step-ups are the most common consequence for failing to meet SBTs. However, information on coupon step-ups is generally not made public, and there is not sufficient information nor precedents in the market to appropriately assess the meaningfulness of the bond characteristics’ variation and potential best practices (V.E 2021). Furthermore, there is also scepticism among investors against coupon step ups because they are worried about the potential reputational harm that could come with profiting from a margin adjustment because of an issuer missing their SPTs (Wass 2021).

Fourth, the premium that investors are willing to pay for an SLB may also be affected by the transition risk that the issuer is facing. Recent issuers of SLBs from the fossil fuel industry such as Repsol carry the risk of stranded assets which will affect their ability to repay their debt obligations, including SLBs.

6. Conclusions and directions for future research

In conclusion, SLBs undoubtably have the potential to encourage investments in zero-emission activities, help issuers align their emission trajectory to the Paris Agreement, and provide capital to economic activities that aid in the transition. However, the ability of the SLB market to realize its potential to accelerate the decarbonization of the real economy at the speed required to limit climate change to below 2°C and preferably to 1.5°C depends on several issues.

First, actors in the SLB market need to arrive at a common understanding of economic activities that have a material contribution to climate change and that need to see ambitious performance improvements to achieve full decarbonization. This shared understanding of credible decarbonization pathways is also needed to avoid the lock-in of carbon intensive economic activities. Work in the EU and elsewhere on a common taxonomy of sustainable economic activities may help market participants in setting material performance indicators and ambitious targets.

Second, science-based targets should become best practice for climate-related performance indicators and targets of SLBs. Having such an external validation and benchmark provides investors with assurance as to the ambitious nature of the targets. However, science-based targets methodologies related to financial institutions have led to controversies over how impactful they can be. Thus, market participants should be aware that overreliance on a specific methodology can carry the risk that the methodology will be challenged in the future with potential adverse effects for the credibility of the SLB market. Issuers and investors should be focused on the actual emissions impacts of any target-setting approach they adopt. Furthermore, reporting practices need to improve to ensure that investors and market observers can easily check and compare the performance of SLB issuers against their science-based climate targets.

Third, the extent to which SLBs can offer issuers with a lower cost of capital to transition their business depends on the perception and preferences of investors. Crucially, lower borrowing costs will only be sustained if investors’ concerns that the performance-linked structure of SLBs allows issuers too much leeway in allocating proceeds to non-sustainable activities and that penalties for missing climate targets do not create sufficient incentives for management to pursue material changes in their carbon footprint are addressed (Liberatore 2021).

Our initial reflections about SLBs also raise several questions that future research should investigate. First, what is the climate-related additionality of SLBs – i.e. what is their ability to promote transitional activities and progress on emission-reduction targets that would not have otherwise happened. Are issuers setting sustainability targets that are already ‘baked-in’ to their operations or are they committing to new and ambitious targets?

Second, future research should investigate how different bond characteristics can incentivize issuers’ sustainability performance. Do coupon ratchets encourage issuers in meeting or even increasing their climate targets – and do performance-linked changes in the cost of capital have a sufficiently strong penalizing effect to deter issuers from missing their targets?

Third, research should also assess the governance system of the SLB market, its interdependencies with market-driven and regulatory changes promoting sustainable finance, and its ability to redirect capital flows towards decarbonization.

Acknowledgements

We would like to thank the anonymous reviewer for their substantial comments that helped to improve the manuscript.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Funding

This work was supported by Marianne and Marcus Wallenberg Foundation [MMW 2016.004].

Notes

1 SLBs like any other bond can be defined as financial instruments as per, among other relevant regulation, the EU’s Markets in Financial Instruments Directive (2004/39/EC).

2 Bloomberg New Energy Finance, as of 31 December 2021. Includes outstanding and repaid bonds.

3 Bloomberg New Energy Finance, as of 31 December 2021. Includes outstanding and repaid bonds.

4 Bloomberg New Energy Finance, as of 30 September 202. Includes outstanding and repaid bonds.

5 Bloomberg New Energy Finance, as of 30 September 202. Includes outstanding and repaid bonds

6 Bloomberg New Energy Finance, as of 30 September 202. Includes outstanding and repaid bonds.

7 ECB to accept sustainability-linked bonds as collateral (europa.eu).

8 EU eyes SLB label in big expansion of sustainable finance rules (globalcapital.com).

9 SSAB issues Sustainability-Linked bond amounting to SEK 2,000 million – SSAB (cision.com).

10 Repsol set to raise 1.25 bln euros from sustainability-linked bond | Reuters.

11 The EU’s sustainability objectives are climate change mitigation, adaptation, the sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and the protection and restoration of biodiversity and ecosystem.

12 EU taxonomy for sustainable activities | European Commission (europa.eu).

13 Bloomberg New Energy Finance.

14 Bloomberg New Energy Finance.

15 HM_Sustainability-Linked Bond Framework_Final_Newfont (hmgroup.com).

16 sse-slb-framework.pdf.

17 tesco-sustainability-linked-bond-framework.pdf (tescoplc.com).

18 Europe’s first sustainable junk bond draws scrutiny over green impact | Financial Times (ft.com).