Finding a ‘free lunch’ in sustainability-linked bond markets

• Many issuers of sustainability-linked bonds see an issuance premium that exceeds the penalty for missing sustainability KPIs
• Rapid growth of issuance shows appeal of more flexibly labeled bonds, but the market needs to address some structural weaknesses to continue to grow
• More transparency on KPI target setting, alignment with Net Zero pathways, and adjustment of incentive structures would strengthen the market’s foundations

One of the enduring maxims in economics is that there is no such thing as a free lunch. However, the rapid growth of sustainability-linked bonds from the first issues at the end of 2018 to more than $120 billion of issuance in 2021, highlights a powerful draw for a relatively new type of labeled bond.

New research from the University of Zurich on this market suggests that companies may have done the impossible in terms of finding a ‘free lunch’, but it may come with a hidden cost that puts future growth at risk unless some structural weaknesses in the market are addressed.

The measure used to investigate was an analysis comparing newly issued sustainability-linked bonds with other issuance in the same currency, issued around the same time, and with a similar tenor. It is the same type of analysis used to look for the ‘greenium’ in the green bond market, where issuers are able to price bonds at higher prices (lower yields) than for other issuance.

Green bonds differ from sustainability-linked bonds (SLBs) because the former are limited to specific uses of proceeds with annual reporting. SLB issuers set issuer-wide KPIs for sustainability impact, often reduction of emissions or emissions intensity, and then have step-up or step-down of the coupon at some point in the future depending on whether the KPI is met or not.

On average, the research found an average penalty for not reaching the sustainability KPI was around 25 basis points (it was 26.6 bps). Meanwhile, the issuance itself was often issued at a premium of close to 30 basis points (29.2 bps) compared to the issuer’s similar unlabeled bonds. On average, the research estimated that about two-thirds of issuers received a ‘free lunch’ where the premium on the SLB exceeded the potential future cost if the targets were not reached.

One of the risks that the SLB market faces is that investors will be attracted to invest in the market to demonstrate their commitment to sustainability, while at the same time facing an incentive structure where they benefit when issuers do not meet their targets. There is currently a significant segment of the market — about a third of issuance — where this risk is present and issuers are paying more to issue SLBs when factoring in the potential penalty if they miss sustainability KPIs.

The remainder of the market faces the potentially different greenwashing risk of attracting issuers trading an immediate reduction of funding costs that will leave them no worse off if they miss the sustainability KPIs they set. The prevalence of callable bonds — especially with issuers that on average have set higher step-up payments — suggests issuance decisions to tap a market where imbalances point towards higher demand than supply are made with one foot out the door, where issuers are leaving themselves a way to avoid the penalty for missing sustainability KPIs.

The SLB market has taken off much faster than the transition-labeled bond market was expected to. The prevalence of sustainability KPIs related to carbon emissions or emissions-intensity reductions indicates many would-be transition bond issuers are opting for SLBs instead because they have more control and more potential for clarity in establishing targets.

Although it is clearly preferable to have transparent KPIs for sustainability, the lack of clear guidelines on how these should be set poses a risk when many companies’ Net Zero pledges are already attracting criticism. With the degree of investor interest in SLBs, and their flexibility to appeal to many types of issuers, it is increasingly important that the market is strengthened. A few items to consider for this effort would include:

• Creation of guidelines and stronger disclosure requirements for the sustainability KPI target-setting process (why was the KPI chosen and how was the target set?);
• Alignment of issuer incentives by reconsidering how SLB penalties are set to sufficiently incentivize issuers to set and reach achievable KPIs that have a material sustainability benefit;
• Alignment of investor incentives to better monitoring, by severing the financial benefit to investors from SLBs missing their targets in favor of the penalty being earmarked for donation to NGOs working to mitigate the impact of the failure to meet a particular KPI;
• Encouragement for climate-related targets to be reviewed against internationally accepted pathways to Net Zero to evaluate compatibility.

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