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Sustainability-linked bonds: a win on several counts

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By Morgan Davis
13 Jan 2021

With Asia’s sustainability-linked bond (SLB) market thrown wide open with the first transaction, there is a case to be made for the opportunities offered to both issuers and investors by this nascent asset class.

Sustainable-linked loans have been around in Asia since 2018, but its bond counterpart had seen no action at all. At least not until last week, when Hong Kong property developer New World Development Co (NWD) sold Asia’s first SLB and the first dollar SLB from a real estate issuer globally. It raised $200m from a 10 year deal.  

There has been chatter about the potential for SLBs in Asia for some time. After all, much of the region is still reliant on coal, and governments and businesses have to walk a tightrope when it comes to supporting and bolstering their developing economies, while finding ways to comply with the increasingly stringent global standards for carbon emissions and other environmental impact.

That creates a dynamic where Asia is home to some of the "dirtiest" companies that green investors avoid — but is teeming with firms that need funds the most to clean up their acts.

Enter SLBs. Unlike green bonds, which for the most part need to be tied to specific green projects, SLBs offer more flexibility for issuers. The money can be used for broader purposes, but the SLBs are tied to a quantifiable performance goal. For instance, NWD committed to use 100% renewable energy in its Greater Bay Area rental properties by the fiscal year end of 2025/2026. That will be a massive jump from the less than 1% renewable energy the company reported using at the end of fiscal year 2019/2020.

In many ways, having an overarching goal is more beneficial to environmental efforts than specific green projects, such as the construction of a solar or wind power plant.

Green projects are of course necessary, but they have a myopic approach to dealing with questions of environmental impact, especially in Asia. There is increasing awareness among investors, governments and others that more needs to be done to retrofit and update existing businesses that are key polluters, rather than just expecting those companies to die a natural death and be replaced by businesses with cleaner practices. These "dirty" companies should be encouraged to transition — with the help of capital markets to do so.

It helps that the promises SLBs make are not without checks and balances. The paperwork, transparency and follow up required for SLBs are in many ways more stringent than that of green bonds.

SLBs come with a penalty should an issuer not meet its targets. NWD has committed to annually purchase carbon offsets equivalent to 0.25% of the outstanding aggregate principal of its notes from 2027 until their maturity if it does not meet its target.

In comparison, SLBs in other parts of the world have come with pricing step-ups that will increase funding costs if an issuer falls short on its goals.

NWD's approach stands out for creating an environmental win-win — and is a structure that should be replicated by other SLB issuers.

This is because even if the borrower does not meet its objectives, the carbon offset purchase creates another environmental benefit. This should be attractive to sustainability investors that want to encourage green practices, rather than benefitting monetarily from a firm’s failure to perform. On top of that, having an explicit penalty should also cut down on green washing, or the practice of using a sustainability project for marketing a deal that in reality has no real environmental benefit.

Of course, SLBs are not for all investors. Dark green investors – those with the most stringent portfolio restrictions – and other funds that exclude certain types of businesses may have to avoid these products. SLBs are, after all, not truly green in the sense of the definition the market has come to accept. These products will, instead, best serve broader environmental, social and governance (ESG) funds that have a bit more wiggle room for the types of products they can purchase.

The path won’t be easy for issuers, many of which could be deterred by the paperwork and requirements of an SLB. But the benefits in the long run will far surpass the initial headaches.   

Take Chinese high yield property companies, for instance, which have recently begun to embrace green bonds, with some even seeing a price advantage for doing so. At the very least by expanding further to using an ESG label, issuers will be able to access a larger pool of investors, and eventually even price their bonds at a tighter level.

Chinese borrowers may also find that the government is supportive of their efforts.

Bank of China, which is known to sell bonds that reflect the government’s agenda, printed its debut transition bond last week. Transition bonds, in some ways similar to SLBs, help upgrade businesses to cleaner practices. For instance, a public utilities company may upgrade existing infrastructure to be more energy efficient. BOC said its bond will support China's decarbonisation efforts, as the country aims to achieve carbon neutrality by 2060.

There are still serious questions about the adoption of both structures. Although SLBs are a great way to incentivise those polluters which want to change but which don’t necessarily have specific green projects, NWD is hardly an example of that – it has already sold green bonds in the past. Bank of China, similarly, is not the ideal issuer of a transition bond. But the market was always likely to start with low-hanging fruit.

The job for bankers now becomes convincing more corporations that there are real benefits from turning to the SLB market, including transition bonds. That will create a new source of business for banks – but it could also have an even more positive impact on the world than green bonds.

By Morgan Davis
13 Jan 2021