Sustainability-linked bonds, the rising star of green finance –

The market for sustainability-linked bonds (SLBs) hit the symbolic $100 billion mark in 2021, one year after they were first introduced, a spectacular growth which is starting to attract the attention of EU policymakers wary about the risk of greenwashing.

$100 billion is “an awful lot and not much” in relation to the market for sustainable investment, that was worth almost $1 trillion last year, according to Nicholas Pfaff, deputy CEO at the International Capital Market Association (ICMA).

Yet, its stellar growth seems to have surprised even seasoned observers like Pfaff.

“If you consider how long it took for green bonds to get to $100 billion, which was almost six years, the SLBs hit $100 billion in only a year. So clearly, it hit a sweet spot in the market,” he said.

Pfaff was speaking at a European Parliament event last week, which looked at sustainability-linked bonds as an instrument to drive the green transition.

By contrast with green bonds, which are issued by companies or governments to finance specific projects like the construction of a new wind farm, sustainability-linked bonds are related to the overall environmental performance of a company.

Banks like Morgan Stanley pay increasing attention to the environmental performance of companies because it can impact their ability to repay their loan, explained Domenico Siniscalco, vice-chairman and head of Italy at the US investment bank.

“And we always look at environmental risk, because it means hidden liabilities, or future possible issues and problems,” he told the Parliament event.

Key performance indicators

Sustainability-linked bonds come with specific targets – or key performance indicators (KPIs) – related to their bank loan. If they meet their targets, the interest paid on their debt will be lower, which acts as an incentive for companies to go green.

Italian energy utility Enel was the first to experiment the instrument, in 2019. Alberto De Paoli, the company’s CFO, said the aim was “to have a general purpose financing” of Enel’s overall transition as a company.

“That’s why we invented this instrument,” De Paoli told participants at the event. “It’s not because we are good guys. It’s not because we want to save the world. But because we are offering a more profitable and less risky company,” he said.

But the growing success of SLBs is also starting to attract scrutiny from policymakers and the wider finance community.

Companies that choose SLBs are free to decide the indicators they will use as KPIs, which gives them freedom to focus on one particular aspect of sustainability, like air or water pollution, the circular economy, or biodiversity, explained Eila Kreivi, chief advisor on sustainable finance at the European Investment Bank (EIB).

“And that’s the good part of the story, which I think is great,” Kreivi said.

However, this flexibility also raises concerns that targets may be too easy to meet. Just like with green bonds, Kreivi believes SLBs “should go further” than business-as-usual.

“This is the same logic that we have seen in the [sustainable finance] taxonomy: in order to be green, you need to make a substantial contribution” to the EU’s wider environmental objectives, she said. “A small contribution is fine, but it’s not enough.”

“I think it would be helpful if the market were to self-organize a little bit better,” Kreivi suggested, pointing to the “great work” already done by ICMA in this respect. “And I think more is needed, because it’s a new product, it only started less than two years ago.”

Jurei Yada, from climate think-tank E3G, also believes issuers need more self-discipline if they want to maintain credibility in the market for sustainability-linked bonds.

“A voluntary standard for SLBs would help improve transparency” by introducing minimum requirements on these bonds, she suggested. “We need to identify the relevant KPIs” and make sure those are “in alignment with the EU taxonomy” on sustainable finance as well as the “climate transition plans” adopted by multinationals under the EU’s Corporate Sustainability Reporting Directive (CSRD), she said .

Risk of greenwashing

Others in the investment community are more critical, and warn that the proliferation of green finance instruments ultimately poses a risk of greenwashing – or false environmental claims by companies.

“If anything, I believe there are probably too many [green] bonds” on the market, said Siniscalco, from Morgan Stanley. “So there is a risk of greenwashing in that respect” because “there is a premium [for companies] in issuing cleaner bonds rather than not.”

His warning is echoed by Paul Tang, a Dutch lawmaker who is steering the European Parliament’s position on a proposed EU law to regulate the market for green bonds.

According to him, the risk of greenwashing must be addressed because suspicion about integrity “affects the functioning of the market” whose ultimate goal is to accelerate investments in the green economy.

“And that function is eroded if there is greenwashing,” Tang warned, saying the market “could certainly collapse if there’s a lack of trust caused by a one or two scandals”.

To address the risk of greenwashing and organize the market for sustainability-linked bonds, ICMA issued guidance earlier this year and put together a registry of 300 KPIs – or key performance indicators. Alongside this, ICMA also provided a registry of methodologies allowing issuers to benchmark SLBs, the best known of which is the science-based target initiative.

However, Pfaff acknowledged the limitations of self-regulation, saying ICMA’s voluntary guidance is “dependent on the input of the market”.

Looking forward, he said the debate on regulation needs to focus on “market integrity and greenwashing” – or whether SLBs actually achieve green objectives or not. And part of that is to determine the level and nature of “penalties” that should be slapped on companies that don’t meet their KPIs.

However, Pfaff said it would be too early to regulate at this point, adding that SLBs “need time to mature” before policymakers start looking at them in more detail.

Regulating the level of ambition of SLBs would be tricky for instance, I have remarked. And consequently, it would also be “difficult to regulate the penalties on a product like this” in a way that makes sense.

“What we could do,” he suggested, is to introduce “certification methodologies” approved by market players which would enjoy “kind of an official status” in the investment community.

Pfaff also pointed to a lack of data on how much greenwashing is actually happening or what it even understood by it. “We don’t have studies on greenwashing,” he remarked, warning that “this very blunt concept” can easily “turn into witch-hunting” unless regulators know exactly what they’re talking about.

A fundamental question for regulators, he said, is whether investors are being misinformed or not. “If that’s what we’re talking about, there’s a lot of existing legislation already out there,” like market abuse, for example, he remarked, saying existing legislation can probably be adapted to address the issue.

“Wherever possible, let’s get some data. And let’s have that conversation. And let’s have targeted regulation if needed,” he said.

EU focused on regulating green bonds

For now, EU policymakers in Brussels are not too worried about SLBs and focus their attention on regulating green bonds.

In July last year, the European Commission tabled a proposal for a voluntary European green bond standard, which is currently being examined by EU countries and the European Parliament.

“Europe leads as the location in the issuance of green bonds globally. The majority of green bonds are denominated in Europe, and indeed the EU Commission is the largest single issuer of green bonds,” said Mairead McGuiness, the EU commissioner for financial services.

However, the continued growth in the green bond market also brings new challenges because “there is less consensus on what is actually green,” she said at the Parliament event. “And this means more effort for issuers to provide their credentials, and more work for investors to verify them,” she said.

So for now, the Commission’s focus is still on completing its proposed regulation for a European green bond standard, she said.

[Edited by Nathalie Weatherald]

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