20 February 2023

Credibility is key for sustainability-linked transactions after bruising 2022

The initial excitement surrounding sustainability-linked transactions (SLTs) subsided towards the end of last year as questions were raised regarding possible shortcomings. Federico Pezzolato, Marie-Bénédicte Beaudoin and Salima Kettani discuss what the market can learn as these instruments evolve

Environmental Finance: What is the outlook and investor interest in SLTs?

Federico Pezzolato: In the second half of 2022, SLTs received significant criticism regarding their robustness. We have also seen a major change in the type of issuers coming to the market. High-yield issuers have almost disappeared due to higher interest rates and financing costs. Because SLT structuring is more complicated than use-of-proceeds (UoP) structures, sub-investment grade companies issuing SLTs may have come to the market with relatively weak frameworks in 2021 and 2022. All those elements may have impacted the perceived quality and integrity of the market.

Marie-Bénédicte BeaudoinHowever, in the first weeks of 2023, we have seen a balanced mix of SLTs and UoP projects and we expect to see this trend continuing over the year, with issuers and investors adopting a more critical and careful approach on SLTs.

Marie-Bénédicte Beaudoin: In addition, criticisms around greenwashing have materialised in this space and it is clear there is a need for further guidance on how to structure those instruments. There have also been some questions around whether there is a "greenium" (green premium) with SLTs. There is not a clear consensus on that aspect.

One thing to watch will be whether there will be a backlog of sustainability-linked bonds (SLBs) that will unlock if market conditions improve over this year. We expect easing inflation and interest rates will result in high-yield issuers coming back into the market.

Another question is whether key performance indicators (KPIs) will be more diverse in 2023. Greenhouse gas emissions (GHGs) represented the vast majority of KPIs in 2022. Will there be a greater inclusion of topics such as biodiversity or social KPIs that are increasingly on the agenda of investors?

EF: Could you expand on the challenges and criticisms that SLTs are experiencing?

MBB: One challenge is the materiality of KPIs and to what extent they are relevant and core to the business of the issuer. The second aspect is the ambitiousness of targets and how much they go beyond "business as usual." Another challenge relates to innovative KPIs and how to evaluate them when there are no existing benchmarks or past performance for comparison. In addition, we think that the financial characteristics of the SLTs and the impact the realisation of their targets will have on the financial structure of a business will be more scrutinised in the future.

Salima KettaniSalima Kettani: Last year's market conditions were challenging. SLBs typically require tenors of five to 10 years. In higher-rate environments, issuers favour shorter maturities, and this consequently prevented some of them from coming to the SLB market last year.

FP: At the beginning, market players were inebriated by the flexibility offered by SLTs and the fact that there is no segregation of the proceeds. Issuers were very happy with this approach. But the instrument is proving to be much more complicated than it first appeared: There is an explicit need to have continuous maintenance of an SLT. While the KPIs are more or less stable, the level of ambition evolves over time.

Reporting and transparency towards investors are therefore fundamental. We have been working with several issuers on updating targets. What they set two years ago is not necessarily seen as robust or ambitious enough in today's context.

MBB: It has become clear that SLTs are not for everyone, and it is not sufficient to simply identify a KPI and get an external validation. It is important to have a robust strategy in place and to have the resources and solid action plan to deliver those results. This is especially important for issuers from high-yield or hard-to-abate sectors who need to establish the credibility of the issuance. Investors will be paying even more attention to the robustness, materiality, and ambitiousness of the targets.

EF: Are the same challenges also present in the loan market?

SK: In the sustainability-linked loan (SLL) market, we have noticed little scrutiny around private transactions. The second party opinion (SPO) demand in this segment has recently increased, assuring that the KPIs remain relevant, and the Sustainability Performance Targets (SPTs) remain ambitious for the term of the SLL. In emerging markets, particularly the Middle East and Asia, we have witnessed a growth in SLL transactions and believe that this trend will continue in 2023.

Federico PezzolatoWe continue to encourage issuers to get an external view on this type of transaction. Also, the reporting on SPTs post-issuance, particularly in the SLL market is not standardised, so it's likely to be decided on a loan-by-loan basis.

FP: We also see different reporting trends in private versus public markets. While private markets may lack transparency, there is usually annual monitoring of the progress on the SPT trajectory. By contrast, we see irregular monitoring in the SPT trajectories adopted in public markets, despite more transparency overall in public instruments and tradeable securities. It will be interesting to see whether private and public markets can have a positive influence on each other over the course of the year.

When it comes to private markets, we try to share the experience we have gained in public markets. For instance, we have developed specific services for loans and in private transactions where the level of disclosure is usually lower. The importance for an external verification is fundamental and it's requested by lenders more and more.

EF: How can issuers better define materiality?

MBB: Using international, national, regional standards and internationally recognised benchmarks is useful. The chosen KPIs should be strictly linked to the issuer's activity and its strategy – impacting the company processes and delivering performance improvements in significant segments of the business, and also on the issuer's stakeholders. Also, the representativeness of the baseline year is important for the level of ambition of the SPT. Issuers should not choose a baseline in a year where there were exceptional events – such as a merger or divestment.

SK: The recent KPI registry by the International Capital Market Association (ICMA) has helped provide a palette of KPIs to guide each sector. There are over 300 KPIs – both core and secondary – to choose from. We notice that issuers and underwriters are already actively referencing it and we welcome this indication provided by ICMA, which will help a more ordered development of the market.

EF: Do you think there will be a widespread acceptance of the structure by both investors and issuers?

MBB: As we saw with the green bond market, we need to give SLTs time to establish themselves and go through this initial phase. They have only been around for three years. It's a learning curve and the market knows there is a need for more guidance. There seems to be appetite from investors, and we have seen a diversification in the type of SLT issuers, such as the first sovereign one in 2022. Maybe SLTs won't overtake UoPs in 2023, but there is potential for them to grow and keep on their current trajectory.

FP: In order to tackle the challenges in the SL market, we will probably see the different instruments grow together in public markets, combining the clarity of the UoP structure with the flexibility of the SLT. We are in a study phase in terms of what these targets have achieved. We need some defaults in the sense that we need to see what happens in terms of financial characteristics. Certainly, this will help the market to strengthen and to evolve.

SK: For issuers that miss their targets it will be interesting to see how it will impact their ESG profile and credit ratings.

EF: Given the challenges in the SLB market, could we see a resurgence of interest in the transition bond UoP structure?

FP: The UoP market is more mature, and investors are adept at scrutinising such products. The main challenge, which may turn into a positive advancement in the long term, sits with the proliferation of taxonomies and local standards that we have seen in the last 18 months. This is also a healthy complication because all these taxonomies, with all their different levels of analysis and detail, push issuers to analyse their portfolios more closely in order to identify eligible projects. This means that there is now a more robust assessment of the projects that can be effectively financed with the UoP structure. And it is easier to implement, relatively speaking.

The transition finance concept suffered at the beginning due to a lack of guidance and no precise definition of what transition is. We have seen various attempts but there is still much room for interpretation for both issuers and investors when it comes to the definition of UoP categories and impact.

In hard-to-abate sectors, we have an incredible amount of assets and CapEx that could be financed with UoP transactions. The guidelines adopted in Japan and the attempt to define transition taxonomy in Canada are good examples of this and it will be interesting to observe how the debate evolves in 2023.

With the emergence of SLTs, it is possible that transition bonds will get a second chance. The market is now more expert in managing the complexities of SLTs and there is a growing awareness that we have to invest in the climate transition effectively.

EF: How has the role of an SPO provider evolved in the context of a more complex environment, both from regulatory and market sophistication perspectives?

FP: As an SPO provider, it remains to be seen how regulation will impact our activity and how it will shape markets. We welcome any indication from regulators that provides more clarity and reduces room for interpretation. Having a solid and science-based approach towards the analysis of the sustainability credentials of SLTs and different frameworks is fundamental.

We work as external reviewers, but we are also sparring partners for our issuers. We have experience working with several different issuers and so we are well positioned to express an opinion as to how they can anticipate potential criticism towards their instruments. We challenge them and we try to push them to improve their approach. Ultimately, the decision is theirs, so we don't intervene in the construction of the frameworks, but we think it's fundamental to work with a valid and solid partner to have a robust SPO in place.

MBB: Some issuers have dropped KPIs or SPTs in the course of the SPO process. We do not hesitate to raise challenging questions (on materiality and ambition) in our reviews, because that helps shape the robustness of the issuers' frameworks and how they will be received by investors. It may take slightly longer but it is worth the time.

Federico Pezzolato is associate director, sustainable finance business manager at ISS Corporate Solutions, Marie-Benedicte Beaudoin is associate director, head of SPO operations at ISS ESG and Salima Kettani is vice president, sustainable finance business development at ISS Corporate Solutions.

To learn more about ISS Corporate Solutions' Sustainable Finance Solutions, contact: SPOsales@isscorporatesolutions.com

By way of background, ISS Corporate Solutions (ICS) works in collaboration with ISS ESG, the responsible investment arm of Institutional Shareholder Services, as the distributor of SPOs. While the SPOs are sold and distributed by ICS, the analytical work to prepare and issue SPOs is performed by ISS ESG.

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