The Roadmap for KPI-linked Bonds in 2020

Twelve years after the first self-labelled green bond issuance, the sustainable debt capital market continues its own constant transformation. The newest innovation is KPI-linked general purpose bonds with the utility ENEL sparking discussions by issuing the inaugural target-linked bond supporting the Sustainable Development Goals (SDGs). Environmental Finance talked with ISS ESG and ISS Corporate Solutions' sustainable product specialists on what lies ahead for this new instrument.

Environmental Finance: Are KPI-linked general purpose bonds a new form of greenwashing or the longawaited entry point for sustainability-focused investors to issuers which have not yet an advanced ESG profile?

Viola Lutz, Head of Investor Consulting Climate: Financing the transition of the entire economy is now, more than ever, necessary to achieve the goals set by the Paris Agreements. With fires ravaging Australia in 2020 and after the UN Climate Change Conference of 2019 reported no progress, KPI-linked bonds are a promising innovation to sharpen investors' focus on supporting the transition strategies of entire companies. They differ from classical green and sustainability bonds in that they allow financing outside of specific projects or use of proceeds categories. At the same time, tracking the achievement of specific KPIs – in the case of ENEL increasing its renewable energy capacity to at least 55 percent of its total by 2021 – introduces an element of specific accountability.

Federico Pezzolato, Sustainable Finance Business Development Manager: We are facing a potential paradigm change and it is understandable that very different reactions occur from different players and investors. Use of proceeds products are well accepted by the market, they are in line with the International Capital Market Association (ICMA) Green and Social Bond Principles, well-established with a number of very well received green bonds issued to date following this model. Assuming the issuer will abide by the commitments undertaken in its framework, the reputational risk connected to such products is relatively low. On the contrary, KPIlinked products present so far, a limited track record, at least regarding bonds, and the market is divided, with some investors having strong reservations because of the potential of greenwashing related to the lack of review of materiality of KPIs, while some others appreciate the clear link to a KPI and to the overall strategy of an issuer. Currently, we do not have any reference point as to what would constitute a "good" KPI-linked bond versus a "bad" one, and KPI-linked products seem to better address the needs of an issuer with a clear sustainability strategy in place and resources to manage a general-purpose portfolio.

EF: But what comparison point is a company's transition or ESG improvement strategy measured against if its ambition-level is entirely self-proclaimed? And what assurances exist that, for instance, while the expansion of renewable energy capacity happens, the use of fossil fuels decreases in absolute terms?

Mélanie Comble, Head of SPO Operations: Transparency and accountability must indeed remain central to the sustainable debt capital market's evolution. KPI-related bonds operate outside of the Green, Social and Sustainability Bond Principles that so far have been the key driver for transparency in the market and an inspiration for the EU Green Bond Standard. In the absence of a commonly acknowledged guideline, the KPI-linked bond market should maintain high standards for keeping innovation in line with climate and sustainability objectives as enshrined in the EU Sustainable Finance Action plan and the Paris Agreement.

EF: So how would you go about establishing such transparency and accountability?

VL: External reviews have helped the green bond market to flourish, and they remain in our view key to ensuring integrity and credibility for this new branch of the market. Transparency concerns will need to be addressed by making the following perspectives part of external reviews:

• Sustainability strategy of the issuer: analyse the level of ambition and overall ESG credentials to ensure alignment with the Paris Agreement.
• KPI selection: assess the relevance and ambition of the KPIs selected for tracking the issuer's progress over time.
• Governance: analyse the stringency of processes for tracking progress and the materiality of associated coupon adjustment.

EF: What factors into analysing the level of ambition of the sustainability strategy of the issuer?

MC: To capture the sustainability strategy of an issuer and the relevance of its ESG improvement objectives, ISS ESG considers for example:

• The existence of sustainable alternative activities and mature technologies relevant for the issuer's operations;
• The contribution of the issuer's products and services to the transition of the global economy toward a more sustainable one; and
• The specific geographical context in which the issuer operates, e.g. local energy mix, available technologies.

Based on ISS ESG expertise in both ESG corporate ratings as well as second party opinions, we are ready to deliver SPOs on transition KPI-linked products to assess the ambition of an issuer's ESG strategy and the soundness of KPIs defined and associated targets.

EF: Given all this – how do you see the roadmap ahead for KPI-linked bonds?

VL: The imperative for sustainability action remains high – if KPI-linked bonds manage to establish similarly high levels of transparency and integrity as green bonds, we should see this instrument gain increased traction in 2020 to complement the "use of proceeds" approach currently dominating the market and allowing issuers more options. So rather than putting the new instrument on the defensive, let's collectively learn from the criticism to help establish this new instrument, to achieve continued growth of the market, and ultimately, a successful low-carbon transition.

The structure of the SPO as we know it is destined to change, as KPI-linked products pose new challenges and question market participants on the robustness of the new types of sustainable finance operations. Table 1 shows the content of the SPOs provided by ISS ESG for use of proceeds operations: three equally weighted pillars assess the issuer ESG strategy, the compliance of the framework with the ICMA Principles and the quality of the assets financed.

The SPO presented in Table 2 for KPI-linked bonds is slightly different: the issuer ESG strategy keeps its centrality but then the quality of the KPIs selected and their governance are considered, to assess (and challenge) their materiality, their ambition and the accountability of the issuer on those KPIs.

EXTERNAL REVIEW: OPINION ON KPI-LINKED PRODUCTS