The use of sustainability-linked bonds as a tool for corporate green transitions is on the rise.
There is a new age drawing upon us: The age of ESG standards. The new age, albeit with a few criticisms of greenwashing, is an unprecedented paradigm where climate change is being tackled at a corporate level. But the real question everyone seems to be interested in is whether the corporate world is on the road to saving the world from burning itself.
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To understand this question, one needs to carefully consider looking at how the company's green financing framework and how it has been adopted. The market currently has myriad ways to finance green projects and also aid companies’ green transition. Apart from green, and blue, sustainability-labelled bonds, the one that is catching investors’ attention is the sustainability-linked bonds. These bonds are forward-looking and are anchored to ESG targets. In other words, if an issuer fails to meet a target, a penalty or a step-up is paid to the lender. A much-contended 25bp coupon step was issued when these bonds were first issued. Companies use key performance trackers to track the company roadmap towards sustainability.
This investing boomed after COP26 in Glasgow in 2021, and asset managers and banks have jumped at the opportunity to provide green financing. COP27 highlighted the need for these financial instruments and discussed methods to increase these investments. In the same year, companies borrowed $859 billion as opposed to $534.3 billion in 2020 as green finance.
One such green financial instrument is sustainability-linked bonds or SLBs. Unlike green bonds which are used to finance specific projects, these projects can be used to finance the green transition. The race towards climate neutrality has seen a spike in private equity firms gunning to issue bonds. India is the 6th largest issuer of green, sustainability, sustainability linked and transition bonds in the Asia Pacific region. In 2021 alone, Indian borrowers borrowed $1.2 billion as SLBs. JSW Steel was the largest borrower of $500 million, to further the cause of reducing emissions from crude steel by 1.95 tonnes of CO2, 23% lower than the previous year by March 2030. If these targets are not met, there is a hike up of a 37.5bp penalty on the remaining life of the bond.
Similarly, UltraTech Cement borrowed a sum of $300 million to contribute to a 22.2% reduction in cement-related GHG gases. Furthermore, has a larger coupon payout of 75bp if the target is not met. What makes these bonds attractive is the penalty associated with not meeting the Key Performance Indicators, that the company uses to track its journey towards these goals. The ICMA outlines succinctly, how these KPIs should be evidence-based reporting and gives companies the freedom to choose the nature of the bond depending on the KPIs.
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At this juncture, companies can decide to manipulate these and that is where SLBs get a terrible reputation. The SLBs are in the line of fire and attracting scrutiny when it comes to setting these KPIs that help companies monitor their performance. These are partially due to the high cost of financing green equipment, which accounts for a company’s major expenditure. JSW Steel just invested Rs 12,000 crores in green technology. Such amounts can only be borne by companies with a huge corpus of funds; smaller companies struggle to raise capital. Another problem that stops the SLBs from being a win-win for investors and the environment is from the supply side, where issuers are not obligated to keep investing in green and sustainability projects. The lack of incentives is hampering the good SLBs can do. Furthermore, the lack of strict regulation is adding fuel to the fire. The ICMA guidelines are compendious but lack enforcement and power to sway companies to put in the frameworks. The lack of regulation is feeding into issuers taking advantage of loopholes in the way SLBs are structured. A working paper by the World Bank wrote that issuers take advantage of lower costs of capital. Some SLB structures have lower penalties and minimise the impact that could be created. Other structures also allow borrowers to push their targets with fewer consequences.
All in all, SLBs can be an attractive green financial instrument but need more structural changes, so that sustainability is not just a distant future but becomes reality. Strong regulations and global corporations should be in the pipeline for emerging economies that can benefit the most from SLBs. Moreover, more research on regional policies to nudge small companies to opt for green financing is also the need of the hour.
References
Sustainability-linked Bonds for Decarbonising Hard-to-abate Sectors in India, CEEW, 13 June 2022
Sustainability-Linked Bond Principles, ICMA, June 2020
Structural Loopholes in Sustainability-Linked Bonds, World Bank, October 2022
The tenacity of ESG investing, The Economist, 16th November 2022