Sustainability-linked bond market participants are weighing demands from issuers for greater flexibility over the key performance indicators embedded in their SLBs. The increased likelihood of issuers failing to meet their targets in this year’s wartime environment is adding impetus to the debate, though some see any softening of this sort further weakening the credibility of a product sometimes charged with allowing issuers too easy a ride over ESG targets.
The topic of what some bankers involved term a “KPI restatement mechanism” remains controversial. Much hinges on interpretations of whether issuers control events they could cite as grounds for not paying step-up coupons if they miss KPI targets.
Yet it is M&A, which companies do control, that seems likeliest to win investor support as grounds for a reset. SLB players point out that some prospectuses already contain wording that allows borrowers to unilaterally amend targets in the event of major acquisitions or disposals. Italian utility Enel, the product’s pioneer and largest issuer, has this discretion, for instance, as does French industrial company Legrand.
Investors’ acceptance of these precedents has led banks to seek buyside support for the principle. “We are working with investors and some of the other banks to come up with some reasonable form of words, which would ideally become standardised in the market that would say, ‘We're going to take responsibility where we screw up and miss targets, but we'll be allowed to do M&A’,” said a sustainable capital markets banker.
Arthur Krebbers, head of corporate climate and ESG capital markets at NatWest Markets, said the development is consistent with established practice in the sustainability-linked loan sector. SLLs predated SLBs.
“It's not unusual for companies to ask their banking group to make adjustments to targets. So it's no surprise that companies would appreciate flexibility also in the bond market – particularly for companies in sectors that are subject to significant consolidation and merger and acquisition activity,” he said.
Tough luck?
Nonetheless, the restatement debate risks exacerbating investors’ concerns over the ambition of some SLB KPIs and potential greenwashing via the instrument. “In that context, trying to create excessive flexibility to make unilateral adjustments to targets will likely lead to pushback from various ESG investors,” said Krebbers, citing the need to maintain a balance between issuer and investor interests.
It also remains unclear whether investors will accept war-related factors such as more carbon-intensive energy mixes as grounds for resetting KPIs if SLBs’ force majeure language is insufficiently comprehensive.
"Investors may say 'tough luck and, by the way, there's nothing in the bond that allows you to restate your target because none of this was ever envisaged’. That situation may be pretty painful,” the sustainable capital markets banker said.
Some investors see the need for resets but call for consistency and transparency. “We definitely are supportive of KPIs being expanded to cover a larger scope of operations. But we also like to have traceability of the previous KPIs and how the company would have been proceeding towards the original target,” said Barbara Calvi, executive director for fixed income sustainable investing at Morgan Stanley Investment Management.
She also favours issuers seeking bondholders’ consent for material KPI resets rather than enjoying unilateral rights to make changes.
Some also think holders of such debt should be compensated financially for KPI changes. “If we can properly price the optionality in the SLB, then we get some sort of fair value for what the issuer should compensate the investors for in such circumstances,” said Ulf Erlandsson, chief executive at Anthropocene Fixed Income Institute.
Another way for companies to compensate investors would be to automatically incorporate more stringent targets into their SLBs if they adopt them at the group level. At least one US corporate has done so, according to bankers.
“It's important that these targets remain consistent and they all are linked up with the most recent decarbonisation pathway that the company has set as part of its strategy, also to avoid impacts on the bond price,” said Calvi. This is “particularly so in cases where the issuer has committed to embed sustainability-linked KPIs in all of their new debt issuances”.
Some investors argue that reset mechanisms also need to apply in situations where the issuer disposes of a high-emitting asset or acquires a low-emitting one – making KPIs easier to meet. “As long as it goes both ways,” said Rhys Petheram, head of environmental solutions at Jupiter Asset Management, who also calls for the necessary mechanism to be embedded in covenants governing deals.
ICMA parameters
The International Capital Market Association – the secretariat to the Sustainability-Linked Bond Principles, which guide the product – has “no formal workstream” on KPI flexibility, according to Nicholas Pfaff, deputy CEO and head of sustainable finance.
Materials have been circulated within a sub-group of ICMA's 153-member SLB working group. The working group’s overall objectives include “monitor[ing] developments in the SLB market and evaluat[ing] if updated guidance is warranted”, according to its terms of reference.
The association does not rule out the topic being discussed more formally in the future, though it views it as currently “beyond the parameters of what we do”, Pfaff said, citing a distinction between its “voluntary guidance for sustainable finance products” and bodies that provide guidance on science-based targets and net-zero pathways. He also highlighted ICMA’s investigation of ways to promote standardisation across SLBs, one of the working group’s current topics.
Even so, “if we have enough market participants come back and say, ‘We really think differently and can we do something on this?’, we're happy to hear the arguments”, he said.