After its step-up, Enel should issue an SLB
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After its step-up, Enel should issue an SLB

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Coupon going up after missed target will not automatically help the market

The sustainability-linked bond market has reached maturity, say its enthusiasts, with last Monday’s revelation by Enel that it would pay a 25bp coupon step-up on €10.2bn of SLBs.

They're right to say so. The core feature of an SLB is that if the issuer misses a target to improve its sustainability, it will pay investors an extra sum, usually a higher coupon. This both penalises the issuer and compensates the investors: an offset to the issuer’s disappointing sustainability performance.

Until this mechanism was actually used, how could market participants know it worked in practice?

There had been a few examples of step-ups before, including by Public Power Corp of Greece.

But there could be no clearer demonstration that the product is fully operational than a step-up being paid by Enel, the Italian power and gas company that invented SLBs in 2019 and is by far the market’s largest issuer, with €29.5bn of the bonds under its belt.

The episode shows, first of all, that the issuer did not try to wriggle out of paying, even though it will cost it €25m a year and up to about €96m if all the bonds stay outstanding for life.

Second, Enel’s step-up goes some way to answering critics who allege that SLBs are a soft market, in which companies set easy targets they are sure to hit, meaning the market lacks bite or even purpose.

This was the biggest and most experienced issuer, and it missed a target on a whacking great sum of bonds.

Russian risk

The miss was caused by the Italian and Spanish governments, anxious to allay energy shortages after Russia’s invasion of Ukraine, compelling power companies to keep coal plants burning longer and harder than planned.

So Enel has not even lost face — an outcome that would probably have been more painful than the money it will have to pay.

Indeed, the company stated categorically in its 2023 Sustainability Report, through which it declared the miss, that without this unexpected curveball, it would have met its target — to cut the greenhouse gas intensity of its power output in 2023 below 148g of CO2 equivalent per kilowatt hour. Instead it got stuck at 160g.

Enel’s decarbonisation of power generation has been impressive, considering that the Science-Based Targets Initiative only required it to reach 246g that year. In 2023 it cut the metric by 30%, although that was partly by divesting its Russian business, which does not mean those fossil-burning plants will close.

Observers have been quick to conclude that the step-up in no way means Enel is straying from its sustainability commitment. It reaffirmed that in the Sustainability Report, and is committed to getting that intensity metric down to 130g this year and 125g the year after.

Running out of steam

All of this is true and good news for SLBs. But there is no point sugaring the pill: the product is in trouble.

On Tuesday the Association for Financial Markets in Europe published a quarterly update on sustainable finance and chose as its headline ‘Further decline in European sustainability-linked bond issuance in Q1 2024’.

Issuance fell 34% from the first quarter of last year, it said, raising the chances that this will be the third consecutive year of declining issuance, since the market’s early peak in 2021.

The sustainability-linked loan product on which SLBs are based is also in retreat, down to just over €200bn in Europe last year, against €300bn in 2021, on Afme’s figures. At least the latest quarter showed slight growth for SLLs, from €45bn a year ago to €51bn.

There is one main culprit — fear of greenwashing. Critics alleging the targets are cushy have worried issuers, and probably more importantly, they are worrying banks. No bank wants to be seen as plugging a product its regulator then wags its finger at. SLLs and SLBs are still getting done, but banks are not promoting the idea with the urgency they once did.

GlobalCapital has dissected the SLL market’s woes elsewhere, and suggested a remedy.

Lack of enthusiasm

But the SLB market has an extra problem. As Commerzbank’s head of ESG research Stephan Kippe wrote last week in a comment welcoming the Enel step-up, “SLBs are almost completely ignored by sustainability-linked investors”.

That may be an exaggeration, but many other bankers have said the same. European regulation has not helped: many investors have decided to interpret the Sustainable Finance Disclosure Regulation as meaning Article 9 funds, the greenest category, cannot show their sustainable credentials by buying SLBs.

At least some Article 8 funds do use sustainability-linked debt in this way, such as an Alcentra private debt fund.

But what most bond bankers agree on is that there is rarely much chance of an issuer obtaining a greenium by launching an SLB. Green, social and sustainable bonds, on the other hand, can still achieve a price benefit, even if this too has been disparaged.

Oversimplifying and putting it brutally, the general view is that investors collectively do not value SLBs enough to pay for them.

Enel begs to differ — its head of group finance and insurance Alessandro Canta recently reaffirmed in a GlobalCapital roundtable: “We crystallise certain premium, otherwise I would have been in trouble because I would have given out to investors optionality for free. If I was not able to crystallise a certain premium, I would have given up 25bp of a step-up without getting anything back.”

Enel has a strong following in the market and analyses these issues very carefully.

But what will shape the fortunes of the SLB product as a whole is broad market opinion.

There is no shortage of potential SLB issuers. Any organisation that issues bonds ought to have sustainability targets, and it could link the bonds to them.

But at the moment, not enough of these potential issuers are convinced investors care for SLBs, and most bankers are telling them there is more evidence investors like green bonds.

The SLB is at risk of acquiring a reputation as yesterday’s fashion, and continuing to dwindle.

At a crossroads

The benefits of Enel’s step-up, hailed by enthusiasts, are real, but they only go so far. Enel honoured its promise — that doesn’t mean the next issuer will. Enel’s target had real bite — that does not prove others have.

Above all, a large step-up caused by a problem outside the issuer’s control may cheer the hearts of investors and policy wonks, but it is unlikely to thrill other corporate treasurers with emulation. In fact, sweat may break out on their scalps — there but for the grace of God go I.

The coming of age that SLB supporters have hailed will not necessarily be a fertile one.

At this point, Enel itself has a role to play. It decided not to issue a separate statement about the step-up, but included the information within the 500 pages of its Sustainability Report. The disclosure there was full and clear, but the company hardly drew attention to it.

Enel declined to give GlobalCapital an interview about the issue, and said it was not talking to any media.

Sustainability-linked bonds, just like green bonds, are about communication. The point of Enel issuing them was to proclaim to the capital market: ‘We’re a sustainable company. Look at our targets — we’re so determined to hit them that we’ll pay you if we don’t.’

How Enel communicates about the coupon step-up will also be vital. If it is important that SLBs survive and thrive — and many believe they are a valuable instrument — Enel needs to back the product it’s created to the hilt.

Up to now, it has done that — and in January this year, after it must have known it was going to miss the target on €10bn of bonds, it issued another €1.75bn of SLBs.

But although the Sustainability Report said Enel would keep increasing the percentage of its debt that is sustainably labelled, from 64% now to 70% in 2026, it did not repeat Enel’s previous commitment to issue all its senior bonds in future as SLBs.

GlobalCapital asked Enel if that commitment was still in place, and the company said: “We will continue to issue SLBs, in fact in line with our 2024-2026 Strategic Plan we are aiming to reach 70% of sustainable finance sources on total gross debt by 2026.”

But the clearest signal Enel could give that it still sees them as a valuable part of its financing and investor relations toolkit would be to issue a new deal, with targets linked to the same goal of reducing the carbon intensity of power generation.

That would decisively say to other issuers: we believe in SLBs.

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