A new financing product, incubated in the syndicated loan market over the past two years, has been transplanted to the bond market. Sustainability-linked loans — and, since Enel’s $1.5bn deal last Thursday, bonds — have a different claim to be responsible investments from the green bonds that have become so common in the past six years.
Rather than the proceeds being allocated to specific green investments, the pricing can be changed during the deal’s life, depending on the issuer’s sustainability performance.
Some in the green bond market are wary of this novelty. Green, social and sustainable bonds have grown up based on the idea that investors’ money was financing specific beneficial actions in the real economy — building wind farms, making investments to reduce waste of energy or water.
Investors cherish the idea that they can know what their euros are financing. A mini-industry of impact reporting is growing up to serve their need to catalogue the environmental benefits they have achieved.
Enel’s bond will raise money it can use for any purpose — including the more than half of its power generating business that is not, at present, renewable, or the 11bn cubic metres of gas it sells every year.
Green bond investors who want to tot up the solar panels and energy-efficient homes their euros have financed may find such a deal troubling.
New product sweeps loans
There was a similar reaction in 2017 when sustainability-linked pricing was introduced in the loan market, and in 2018, when the product snowballed.
“They’re not green loans — there are no green assets,” was a common objection from green finance aficionados.
Peace has been declared on that subject, since everyone has agreed to call the pricing ratchet loans “sustainability-linked”, leaving “green” for use of proceeds deals.
But what has been incontestable is the popularity of the sustainability-linked product. Its most obvious attraction is that it suits a much wider range of issuers than use of proceeds debt.
Companies that are making green efforts here and there, or across their whole business, do not necessarily have a pile of green investments running into the hundreds of millions. Or they might find it hard to track and record them all. Many companies do not issue bonds at all.
For all these, it is much more straightforward to negotiate a loan with relationship banks, in which the margin can be reduced if the borrower hits a sustainability target. Usually, there is an equal and opposite penalty increase if the company backslides.
External ratings on the company’s environmental, social and governance (ESG) credentials are the easiest metric for many; other companies use an internal key performance indicator (KPI).
Enel cracks it
Whether this could ever be done in the bond market has been discussed for a while, but it was widely believed to be a way off. Bond investors liked nice, simple instruments and could not haggle with the issuer over terms during a four hour bookbuild.
That changed in May when Dürr, a German engineering company, launched a Schuldschein with sustainability-linked pricing. If Schuldschein investors, who have no relationship with the borrower, could see their way to buying such a deal, why not bond investors?
The story leapt forward on Thursday when Enel launched and priced its $1.5bn deal — also its first SRI financing in the dollar market.
Enel and its advisers made it super-easy for bond investors. There is only upside for them. Enel has set a target — increasing the renewable share in its power generation fleet from 45.9% now to 55% by the end of 2021. If it fails to hit this deadline, even by a day, it will have to pay investors a 25bp coupon step-up. That’s it.
Bond buyers will love it
Green bond purists may furrow their brows at this. It certainly doesn’t comply with the hallowed Green Bond Principles.
The purpose-built green bond funds that many asset managers have opened may not want to buy it, and may not be able to, if their documentation is written strictly.
But that is no matter. It is a new product. It can find its own investor base.
The success of Enel’s deal was convincing. It got $4bn of demand and Enel said the deal had saved it 20bp, compared with a normal bond.
The loan market history provides plenty of evidence that companies will find this product appealing.
Bond investor demand has so far been tested only once. But there are many reasons to think investors will lap up such deals.
First, investors are desperate for new paper. The green bond diet is a pretty unvarying one for a credit investor. Nearly all the deals are from the public sector, commercial banks or four industrial sectors — utilities and power, property, transport and construction. Swathes of the economy are absent.
If a fresh range of companies can be tempted to issue sustainable debt, investors who can be flexible about the structure will welcome it.
The full Monty
Second, the price varying structure has direct advantages for investors. Crucially, this instrument addresses the activities of the whole organisation, not just the subset of its assets to which a green bond is linked.
Modern, orthodox environmental, social and governance investors use ESG analysis to learn more about the invested organisation than they could with conventional financial research. They believe this gives them insight into how to price its securities, enabling them to reap lower risk or higher returns.
In this kind of investing, green bonds are useless. Their green elements tell the investor nothing about how the whole organisation is going to behave — which is what will affect its risk profile and ability to generate returns. If an issuer is hit by an environmental disaster, its green bonds will sell off just as much as regular bonds.
ESG investors tend to justify buying green bonds by referring to a halo effect — saying that ‘issuers that issue green bonds tend to be more conscious of sustainability all round, and hence are better risks’. It may often be true, but it’s hardly a rigorous argument.
Strictly speaking, green bonds also do nothing for the ethical investor. If your aim is to ensure you do not finance anything bad, you have not achieved that by buying a green bond. By financing the issuer, you help it — and make it easier for the organisation to perform all its activities, whether these are in the green asset portfolio or not.
Both ESG and ethical investors need to look at the whole activities of an issuer.
Wagers of virtue
Many investors see green bonds as ‘impact’ investments. In a sense, they are doing something similar to hardcore, ambitious impact investors — pushing their money towards good purposes.
But nearly all green bond issuers are creditworthy organisations big enough to issue in the capital markets. A green bond may save the issuer some basis points if it goes well at launch, but this financial incentive is not going to be material enough (with the interesting possible exception of the mortgage market) to alter its calculations when it decides whether to conduct a given green project.
Investing in most green bonds therefore does not bring any green projects into being that otherwise would not have occurred. Their ‘impact’ is very gentle.
Enel committing to increase its renewables share from 46% to 55% is a genuine, measurable change — especially if the renewable assets are truly low carbon, such as solar and wind, and the dirty plants are being closed down, rather than sold.
Enel is not making this shift because of the bond, any more than it builds renewable energy plants because it can issue green bonds, as it has done three times in the past.
But the bond is a very public marker that Enel is determined to achieve the target — it’s like betting your friend you can climb a mountain, rather than just saying you will do it.
Since conventional green bonds’ claim to have caused the creation of new green assets is very slight, why is the claim of a price-ratcheting bond to have caused the same any weaker?
The Green Bond Principles executive committee will discuss the issue in the autumn and try to reach a consensus position on the new instruments.
The debate has not even begun yet, so it would be rash to prejudge it. But GlobalCapital’s hunch is that it will do as the Loan Market Association did, and embrace the new product. Do not be surprised if in 2020 we get the first version of the Sustainability-Linked Bond Principles.
There are many different ways to do responsible investing, which appeal to different investors. Thankfully, they are free to choose what they do. Some find the kind of connection with sustainability they achieve through green bonds rewarding. Others are bound to find the price-varying structure appealing.
As Enel’s deal showed, it fits well with ESG funds, which are used to considering the issuer in the round, rather than a defined pool of assets.
Neither kind of bond is in itself likely to bring about the greening of the economy. Heavier measures will be needed for that.
What such instruments have proved very effective at doing is generating discussion and attention. The capital markets’ engagement with sustainability has been furthered because participants had specific green bond and loan instruments to think about.
Each of these presents a talking point. Has the issuer done right? Is it really green? Should investors buy it?
A host of conversations springs up, within the issuer’s staff, between it and the market, and between market participants and the rest of society.
Price ratchet bonds like Enel’s will raise the attention in the debt capital markets to whole company ESG investing — a welcome rebalancing, which had already begun a couple of years ago, after the very green bond-focused thinking of the middle of this decade.
Investors will relish the chance to buy into bonds that — like green bonds — ask nothing of them in terms of risk, but give them a free extra, the chance to believe they are supporting a company’s shift towards greater sustainability.
In the process, all will think much more about what trajectories individual companies ought to be on, how far they are still from true sustainability, and how they can speed up. That’s the right conversation to be having.