06 December 2019
Meeting the European Commission's sustainability objectives requires innovation, argues Jacob Michaelsen
There has been a lot of discussion recently in the market around various new attempts to work with sustainability in finance. Indeed, some have called out the excessive creativity in the market when it comes to labelling sustainability-focused bond transactions.
Such discussion, and even objective criticism, is entirely appropriate. I appreciate that we need to be critical of new structures (just as we need to be critical about existing structures as well), but it is important to recognise that the financial markets need innovation if we are to move forward.
As I see it, the European Commission has taken the first steps to set the rules of the game through the Action Plan. It is up to us in the financial markets to "play the game" and come up with the tools needed to support the main objectives 1.
In doing so, we should look to build on proven success stories but also aim for further advancement that recognises the challenges we face and the tools at our disposal. Specifically, we should maintain a strong focus on transparency and ESG-integration as two key parameters. The green bond market has given us transparency in the form of "use of proceeds" (which, as a concept, has even extended beyond the green label itself), but they do not provide us with much support for ESG integration.
From this point of view, it should come as no surprise that I welcome the approach by Enel 2 to use more fundamental, broad-based metrics for incorporating sustainability into finance. This is not to say that I believe there is no room for improvement, but rather that we should allow ourselves to use the Enel case as a springboard to further explore the notion of financial instruments that integrate broader ESG-related components into the structure.
Two relevant perspectives on the Enel SDG-linked GCP bond
There are two relevant and separate lenses through which to look at the Enel structure. It is important to recognise both and not confuse them if we want to have a constructive discussion on the validity of these bonds.
The first is the structural component (e.g. step-up, ambitiousness of the targets, etc.), something which should be fair game for objective discussion. This is largely something we can figure out through a traditional market-based approach and benchmarking. The second perspective is the relevance of the target-linked approach itself. This is evidently where we have the thorniest issues and where the discussion becomes subjective. These issues can all largely be boiled down to a comparison with traditional green bonds.
"The inclusion of targets provides an even more direct measure of impact than traditional green bonds"
I welcome the addition of the target-linked structures for the following reasons:
1. They take nothing away from traditional green bonds.
Yes, some would argue that they allow companies to "cut corners". Some have even called them a form of "greenwashing". I understand the point of view of dedicated green bond portfolio managers who would like to see as much supply as possible in the traditional green bond format (so would I). Yet the target-linked structures do not reduce the available assets and hence should not reduce the supply of green bonds. As we have seen in the loan space, both "use of proceeds" and "target-linked" instruments can co-exist.
2. They allow for a stronger focus on "strategic alignment".
A commitment with financial consequences is one of the most tangible incentives for companies to align their strategy with the 2050 target. Using such target-linked structures thus allows them to highlight the broader transformation of their company rather than focusing only on specific projects that might not be indicative of the entire company. It is, of course, still important that such metrics are still indicative of the whole company and materially relevant.
3. They complement the "use of proceeds" approach.
Companies will have funding needs regardless of capital expenditure (Capex) plans. Yes, some of this will be for general corporate purposes (GCP) type funding and operating expenditure (Opex) related activities – some/many that are crucially needed to support the Capex themselves. Putting additional restrictions on these types of financing can only be a positive change.
4. They allow for better ESG integration and a focus on "impact".
By providing clear and tangible targets, the companies can increase transparency and allow more detailed discussions that may be relevant for investors when integrating ESG in their investment decisions. Further, requirements for meeting targets may result in an even stronger focus on reporting and data materiality, which should also be welcomed by the investors. Finally, the inclusion of targets provides an even more direct measure of impact than traditional green bonds.
Obviously, the discussion of the relevance of target-linked bonds is more nuanced than the four points above would indicate. That said, we should not dismiss these bonds outright, but instead examine these through a proper discourse – something which, in my view, is still missing in the market.
A thought experiment on how target-linked bonds might help us target the objectives
To underline my point, let me propose a hypothetical example: imagine a portfolio manager holding an equally weighted portfolio of 20 bonds from the utility sector. Of those 20 issuers, 10 decide to issue target-linked bonds (with a link to the issuer's total share of renewable energy capacity, as in the case of Enel). In order to meet the thresholds in the covenant, they can decide to either invest in more renewable capacity or sell off non-renewable capacity.
Recognising that it may not always be feasible to identify relevant projects that meet both ESG and economic thresholds, they choose to sell off some parts of their non-renewable capacity to meet the target. For simplicity's sake, let's assume that these assets are sold off to the other 10 utilities in the portfolio. For a portfolio manager holding an equally weighted portfolio, the average impact is the same. However, by shifting portfolio weights towards the 10 issuers with target-linked bonds, that portfolio manager will be able to reduce not just the environmental impact of the portfolio but likely also the risk of stranded assets 3.
As more portfolio managers recognise this, more capital will be shifted towards the 'greener' investments (objective 1 of the European Commission's Action Plan), the portfolio managers will have specifically been able to use sustainability measures to improve risk management (objective 2) and overall we will have ensured that a tool for working with longer-term impact is available in the market (objective 3).
Let's focus on the broader direction of the market
To reiterate the crux of my previous opinion piece on transition bonds, instead of focusing on specific transactions, we need to address the broader direction of the market with regard to labelled finance and specifically the link to ESG integration. Now is the time to do this.
Enel's SDG-linked bond is a good step in that direction. As highlighted, we will need to further discuss this in the market – but keeping in mind that we should keep the discussion of structure (e.g. step-up vs step-down, thresholds, etc) separate from the discussion of the relevance. Further, we might have to broaden the focus so that the targeted metrics are more appropriate and descriptive of the entire ESG story of a company, while of course balancing it with the feasibility of providing external verification of these. A good place to start could be to assess these metrics through the Sustainability Accounting Standards Board's (SASB) Materiality Matrix. Another option could be to focus on the ESG score, as we have seen in the loan market.
By including target-linked bonds in the mix, we allow ourselves to work more specifically with ESG data. And by working with the ESG data as part of the bond structures we can further help the market focus on the material aspects and, in turn, standardise this burgeoning part of the market as well – something which should be a welcome development.
Jacob Michaelsen is head of sustainable bonds at Nordea.
1. The European Commission's Action Plan gives three main objectives: 1) Reorienting capital flows towards sustainable investments, 2) Mainstreaming Sustainability into risk management, and 3) Fostering transparency and long-termism.
2. I have referred to the UN SDGs only specifically in the context of highlighting Enel's bonds. Instead I refer to the overall structure more generally as "target-linked". The appropriateness, or lack thereof, of referring to the SDGs in this and other types of finance is a topic for another discussion.
3. Of course, the climate impact of these non-renewable assets will persist until they are finally closed down. However, as more and more companies sell of these assets they will depreciate in value and should, over time, become so economically unviable that it will be cheaper to shut them down / decommission them.