The unique Auckland Council sustainability-linked bond (SLB) could help point the market in a new direction, reports Ahren Lester
The Auckland Council sustainability-linked bond (SLB) will see it make a donation if it fails to hit its target. This donation-based structure is unusual in the SLB market, which predominantly sees issuers' coupons 'step-up' if a target is missed.
"We were unsure what the [investor] reaction would be to this, as we have not seen it much at all before," Auckland Council treasury sustainable finance manager Sophie Baillie tells Environmental Finance, describing the structure as "quite innovative".
The donation-based SLB structure has proven relatively popular in Japan, but has not seen much use in other markets. However, some market participants argue that it tackles two major challenges facing the SLB market currently – the uncertainty about what the final coupon will be, and "the moral hazard of having investors benefitting from failure [when a step-up is applied]".
Fully embraced
Auckland Council treasury head Andrew John says he was initially "sceptical" that investors would be supportive.
"But I was surprised that none of the investors ever raised that as an issue. In fact, they embraced the whole concept," he says.
Indeed, John says subsequent conversations highlighted that many investors were uncomfortable with the "contradictory" sustainable investment outcome for investors in getting paid more when sustainability targets are missed.
"[The investor response] opens the door for SLBs of this structure, because investors did not have a negative reaction to it at all," he says. "It takes away the challenges of 'traditional' SLBs now, and makes it easier for them to invest in these products. For us, that is the takeaway from this transaction."
Westpac New Zealand (NZ) sustainable finance head Joanna Silver tells Environmental Finance investors appreciated that it would be easier to price in the secondary bond market without this variability in the coupon. Indeed, she believes that the reception of this structure could also represent an important avenue for SLBs amid lacklustre growth of the instrument in recent years.
"We actually think that this might help pave the way for future SLB issuers – in New Zealand, and elsewhere – as investors are not feeling that [variable pricing] concern," she says.
Good precedents
Aware they were breaking new ground with this instrument, Auckland was keen to ensure that the transaction proved as robust as possible. For example, there was a fear that investors would be "uncomfortable" with the fact that the donation would only take place after the maturity of the bond due to the short three-year tenor of the bond and longer reporting timescale for the target.
Silver said this was undoubtedly a "tricky" element to tackle, but this was made easier by the credible sustainable finance history of Auckland, which has already raised $2.4 billion through green bonds since its debut in 2018, according to Environmental Finance Data.
"[The investor response] opens the door for SLBs of this structure, because investors did not have a negative reaction to it at all. It takes away the challenges of 'traditional' SLBs now" – Andrew John, Auckland Council
"We looked closely into what do we need to put on the term sheet and in the investor presentation terms to make sure that this structure can be adopted by others and still ensure integrity across the broader market," she says.
For example, the documentation obligates the council to tell all investors who held the bond at maturity that it has made the donation payment even after the deal has matured. In addition, there are also declassification provisions in the bond by which the bond will lose its 'SLB' label if the payment is not made.
"This might seem a little odd [to declassify the bond] if it is already matured," Silver says. "But, actually, it has a reputational impact. And we really tried to think of how we can give the bond 'teeth' [for investors] even though the donation payments are post-maturity."
'Incredibly valuable structure'
The issue attempted to tackle some of the criticisms levelled at SLB transactions in the past – for example, by ensuring the bond is not callable before the target observation date.
"We looked at all of the shortcomings that the SLB market suffered in the first couple of years, and we considered how we can circumvent these to create something that is locally and globally relevant, applicable and scalable if other people pick it up," Silver says.
All this effort was intended to provide a credible case study for the market as it looks to bolster support for the beleaguered label which has seen issuance plummet since 2021. Indeed, Silver argues SLBs are a "fundamentally important structure" that needs to find ways to gain wider acceptance in the market.
"A sustainable bond market being use-of-proceeds-based is always going to be constrained to those [issuers] who are generating a sustainable asset base," she says. "But, anybody can issue a sustainability-linked bond if they are a credible bond issuer with clear targets and strategic alignment to the principles. So, we think it is an incredibly valuable structure."
Tangible target
John says the "simple" target chosen – to plant a million native trees by the end of 2027 – "resonated" with investors.
"Planting trees is tangible [as a target]. People could identify with it. Whereas some of the other targets [used in SLBs] can be quite confusing."
Silver says planting trees provides an emissions reduction benefit – the most common SLB target – through carbon sequestration but also provides something "significantly greater" through social, economic and cultural benefits.
"Natural infrastructure can provide carbon sequestration, improve water quality, reduce flood risk, enhance climate resilience and then all the social and cultural benefits [of more public natural spaces] that wrap around all of that.... It really spoke to people in a way that is a lot more tangible than an emissions reduction target" – Joanna Silver, Westpac NZ
"Natural infrastructure can provide carbon sequestration, improve water quality, reduce flood risk, enhance climate resilience and then all the social and cultural benefits [of more public natural spaces] that wrap around all of that," she says. "So that is another reason why it was such an incredibly exciting and important transaction – it really spoke to people in a way that is a lot more tangible than an emissions reduction target."
There was also an emphasis on ensuring there is a clear link between the original target included in the SLB and the recipient of the donation, which Silver describes as a "really important" feature.
If Auckland does not meet its tree-planting target, a donation will be made to organisations involved in the restoration of native forests.
Auckland's Baillie says: "Investors really liked it and were very supportive about what and why we were doing with it. Ultimately, we want to deliver a benefit for
Aucklanders. So, any additional cost that we may incur in the future [for missing our own tree-planting target] is powered back into providing benefits for them through the planting of more forest."
Broad appeal
Such was the demand from domestic investors, Westpac NZ debt capital markets head Mat Carter says Auckland was able to significantly upsize the transaction.
The council initially planned to raise at least NZD100 million ($60 million) from the deal but, with orderbooks reaching NZD345 million, Auckland was able to set the final issuance amount at the maximum NZD250 million.
John adds that the transaction also saw larger than normal ticket sizes from some investors, and highlights "broad participation and strong demand".
Although exclusively focused on New Zealand investors, Silver says there was interest beyond the borders of the country of five million people. For example, an Australian investor contacted Westpac to participate in the deal.
With Auckland Council having investors globally, Silver says the "appetite and enthusiasm" for this innovative transaction is a "really exciting opportunity" for the "nimble" New Zealand sustainable finance market to potentially point the sustainable bond market in a novel direction.
Photo credit: Te Rau Puriri Regional Park tree planting, Auckland Council